Energy Insider: Future of Energy

Adjusting the Cost-of-service Rate Model: A Win-Win for Utilities and Consumers?

by Bob Shively, Enerdynamics President and Lead Facilitator

“Throughout the economy, companies are finding efficiencies and operational benefits by meeting their needs through service provided by third parties rather than investing in physical assets that they own and manage. Utilities are no different.”
~ From Utility Earnings in a Service-Oriented World, AEE Institute, January 2018


Finding benefits by contracting for services is ideal for most companies, but for utilities it creates a problem. Under the utility cost-of-service model used for U.S. investor-owned gas and electric utilities, the primary way to increase earnings is to increase rate base by investing in new capital assets. Yet contracting for services takes away this opportunity. Utilities in many regions have already lost opportunities for capital investment in rate-based generation by deregulation of wholesale markets. 

Now utilities face loss of investment opportunities in two other areas: IT systems and Transmission and Distribution (T&D) infrastructure. Consumers may benefit from utility contracting in these areas, but for utility shareholders the result of contracting is a loss of potential income. Let’s first explain this, then we’ll look at ways that regulators might adapt the cost-of-service model to align consumer and shareholder interests. 


In each of the cases above, the utility has two alternatives to satisfy its needs. In the case regarding Meter Data Management System (MDMS) software, the utility can develop the software itself or it can contract to use a third-party’s cloud software. In the case of the overloaded substation, the utility can make capital investments to upgrade the facility or can contract with various distributed energy resources (DERs) to ensure the capacity of the existing facility is never exceeded. 

Traditionally, utilities have not had the second alternatives so they've built capital assets. Doing so allowed these expenses to be rate-based and resulted in increased earnings. But in today’s world, it may be a better solution for the utility to contract for a cloud-based IT solution. And we are beginning to see cases where utilities can keep lower costs to consumers by contracting for DERs rather than upgrading substations or lines. 

This creates a quandary for utilities because while they are driven to pick the best solution for ratepayers, doing so will result in lost opportunity for earnings through growing the rate base. And if the expense association with the “better” solution had not been included in rates in the last rate case, the utility risks over-spending and seeing current earnings shrink below authorized levels as well.

Regulators are studying ways to tweak the cost-of-service model to avoid putting utilities in this situation*. Here are some ideas being tested in various jurisdictions:

Incentive adder to utility earnings for “Non-wires Alternatives” (NWAs)
Under this methodology, the utility is allowed to increase earnings by an amount equal to a percentage of the contract cost. A current example is California’s DER Adder, which is used as an incentive for utilities to find NWAs to avoid system expansion. When the utility contracts for DERs as an alternative (like in the second example above), the utility is allowed to increase authorized earnings included in rates by 4% of the contract expense. In essence, the utility is being paid an earnings incentive to forgo the capital investment.

Capitalization of a pre-paid service contract
In this case, the utility pre-pays the total service contract fee for a specified term.  Then the total cost of the fee is defined as a regulatory asset and the utility is allowed to put it into rate base in the same manner as an investment in a capital asset. The utility then earns a rate of return on this expense just like it earns a return on capital expenditures.  A current example is the New York Public Service Commission (NYPSC) which has allowed utilities to capitalize pre-paid multi-year leases for software.

Shared Savings for NWAs
This methodology would pay the utility an earnings increase equal to a percentage of the ratepayer benefits from contracting. The NYPSC approved a shared savings methodology in 2017 which would provide utility earnings incentives equal to 30% of the difference between the lifetime cost of a capital solution and the cost of a NWA contract solution.

These are examples of a few ways that utility commissions are providing earnings incentives to utilities while encouraging non-capital solutions. These methods allow the basic cost-of-service model to stay in place while aligning ratepayer and shareholder interests when contracting is a superior outcome. We can expect to see commissions around the U.S. continue to innovately reward utilities that find effective solutions to system needs.

Do your utility managers and supervisors need to understand the details of how rates are traditionally set and how that is changing in the new utility landscape? Enerdynamics’ Utility Ratemaking: Now and In the Future seminar will provide your leaders the knowledge they need to make solid business decisions. Contact us at or (866) 765-5432 x700.

*These methods are studied in detail in the paper Utility Earnings in a Service-Oriented World, AEE Institute, January 2018 available at

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