According to the key ratemaking principles identified by Bonbright et al in the Principles of Public Utility Rates (1961), rates should have practical attributes including “simplicity, understandability, public acceptability, and feasibility of an application.” Specifically, the goal of protecting the interests of consumers may be linked to the principles of non-discrimination, cost causation and avoidance of cross-subsidies, while the goal of promoting economic efficiency and cost effectiveness is consistent with the principles of financial stability and ensuring a fair rate of return. Other key principles include incentives compatibility and administrative simplicity and transparency.
Non-discrimination: similarly situated customers should face similar terms and conditions. Whereas competition, in theory, will assure that customers with similar tastes and preferences face a similar set of choices, in a regulated environment such an outcome is assured only through enforcing non-discrimination in rate design.
Cost causation and avoidance of cross-subsidies: one of the most fundamental principles of utility rate design is that the customer that causes a cost to be incurred should pay that cost. If cost causation could be perfectly identified, cross subsidies (either between or within customer classes) could be avoided.
Financial stability and fair rate of return: rates must be set at a level which enables the utility to meet its statutory obligations to serve, while earning a commercially reasonable return and generating sufficient cash flow to support necessary investment.
Incentives compatibility: rate design should, where possible, provide appropriate incentives to both the utility and consumer – namely (1) encouraging utilities to reduce costs, while ensuring reliable, safe, and quality service for customers, and (2) discouraging inefficient consumption on the part of customers. Thus, rates should largely align the interests of the utility and its ratepayers.
Administrative simplicity and transparency: rates should be straightforward for customers to understand. Complex rate designs increase costs to consumers, and may result in more time being spent proving that the rate design is indeed fair to all customers. Ratemaking mechanisms should also be appropriate for the jurisdiction in which they are applied – complex rates in regions with poor data and understaffed regulators may be impossible to administer.
