Cost-based Rates, Part 2

Carl Brown, President

GettingGreatRates.com

Hopefully, the cost-based rates article in the previous issue convinced you that you DO want cost-based rates. The concept, in a nutshell, is this. If a customer causes the utility to incur a cost, that customer should reimburse the utility for that cost.

You arrive at cost-based rates in two phases:

  1. “Classification” This is the process of deciding the nature of costs – fixed, variable and capacity-related. That was covered in the last issue. And,
  2. “Allocation” This is the process of divvying costs out to customers. It is covered here.

The result of classification is a set of total costs: fixed, variable and capacity-related. Allocation will be demonstrated using this example situation for the town of Ratewell.

First, we need data. Most of Ratewell’s data is shown in Table 1.Ratewell is a small town with relatively low costs. It’s customer base is fairly uniform; mostly residential with three-quarter inch meters and a few commercial customers with larger meters.

Ratewell wants to stick with simple rates – the same minimum charge for all customers, a level unit charge and no usage allowance.

Table 2 shows how to calculate Ratewell’s minimum charge. Every customer would pay this base fee every month.

Table 3 shows how to calculate Ratewell’s level unit charge rate in dollars per 1,000 gallons. The rate of $5.00 per 1,000 gallons is the average variable cost of the water. If Ratewell wanted to assess inclining or declining rates, it would still need to recover an average of $5.00 per 1,000 gallons to cover these costs with unit charges. But, then, those rates are not simple so they are not for Ratewell.

Note that the rates calculated in Table 2 and Table 3, assume that capacity costs will be recovered through some other rate. Thus, if Ratewell did not want to set other rates to recover these costs, these costs would be classified into the fixed and variable costs, boosting one or both of those fees a bit.

Ratewell’s customer base is mostly served by small meters. Thus, Ratewell could disregard capacity costs, classify all costs as fixed and/or variable and calculate a level minimum charge and a level unit charge. In this way, capacity costs would be recovered from minimum and unit charges as they were classified. That is probably fair enough for Ratewell.

But, let’s look at Ratewell’s rate structureif it included meter size-based minimum charges. (Tap-on fees are calculated nearly the same way but they are disregarded here.)

To do that, the math gets harder and someone must make some value judgments, too:

  • Does Ratewell want to recover capacity costs from tap-on fees? From minimum charge surcharges? From a combination? Should Ratewell recover all peak flow capacity costs from these special fees, or some of these costs from regular minimum and unit charges instead?
  • How competitive does Ratewell want its tap-on fees to be with neighboring towns so Ratewell can compete for development?

The fairest, easiest and most defensible method I have found for calculating peak flow capacity cost minimum surcharges and tap-on fees is to base the cost allocations on the American Water Works Association studies of the sustainable peak flow capacity of different meter sizes. In real life, this is a complex and integrated calculation. And, some subjectivity is involved. For these reasons, I recommend this. If your utility might need such a rate structure, seek help from a rate analyst.

However, to give you an idea of what the results might look like, review Table 4.

As you can see in the “Surcharges Collected From Each Meter Size Class” column of Table 4, the one inch and larger meters will only pay an extra $2,708 per year. In Ratewell’s case, that is not worth the hassle factor. But if there were more two inch meters or especially if there were just a few four or six inch meters, where the “Flow Capacity ‘Share’” dollars really jump up, surcharges would be well worth the effort.

To conclude, to arrive at fairly structured and adequate rates, you need to classify costs and then allocate them to ratepayers through a base minimum charge, perhaps surcharged to recover capacity costs, and unit charges. Be sure to aim at rates that are appropriate for your situation. If your utility is small and has only a few larger meter size customers, a single minimum charge and a level unit charge may do the trick. Otherwise, you may need help from a rate setting specialist to get appropriately tailored rates. Ah, just the reason we and the Wyoming Association of Rural Water Systems initiated the Wyoming RATES Program, at

Do rate setting right and your ratepayers, and your utility, will be (relatively) happy and well-funded.

Carl Brown is President of GettingGreatRates.com, which specializes in water, sewer and other utility rate analysis. The firm also serves as the RATES Program rate analyst for the Kansas, New Mexico, North Dakota, Virginia and Wyoming rural water associations. Contact: (573) 619-3411;

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