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Regulation and Rates for Electricity


Electric utilities have historically been franchise monopolies, vertically integrated from power production through transmission, distribution, and customer service with no competition from other electric utilities. However, in many parts of the country, electric and gas utilities do compete. Rates charged by these utilities were determined in a regulatory proceeding: Electric utilities proposed rates that compensated them for their expenses and allowed them to earn a reasonable return; state regulatory commissions reviewed and approved the proposals.

This historical relationship between electric utilities and their regulators is undergoing a dramatic change. Policymakers are restructuring and deregulating portions of the electric industry. Restructuring of the electric industry is consistent with the deregulation of other U.S. industries since the 1980s. The objective in "restructuring " is to increase efficiency, lower costs, increase customer choices, and lower the prices paid by consumers in restructured industries.

As in other industries, restructuring of the electric industry is a response to underlying conditions in the industry. Policymakers are responding to two phenomena. First, there is a disparity in retail electric prices among states and regions. For example, the average price of electricity in New England states such as New Hampshire (nearly 12 c/kWh) is almost three times as large as the price in low-cost states such as Idaho and Washington (approximately 4c/kWh). Second, advances in information technology will make it possible to perform complex real-time functions.

In restructured electric markets, the vertical electric monopoly will no longer be the sole provider of electricity. The generation, transmission, distribution, and customer service functions will be separated. The upstream generation function will be competitive, allowing new, any power producer to produce and sell electricityin any service territory. The transmission and distribution functions will continue to be regulated, but will be required to allow access to power suppliers and marketers. This separation or "unbundling" of the industry is necessary to provide nondiscriminatory access for all suppliers of electricity. Customers will have their choice of electric suppliers.

In these restructured electric markets, prices will be determined more by market forces and less by regulatory proceedings. To some, introducing competition will promote more efficient markets, providing the proper financial incentives for firms to enter or leave the industry. In this way, consumers will benefit from lower production costs and, hence, reduced electricity prices. To others, restructuring will increase electricity prices for some customers, sacrifice the current environmental and social benefits, and jeopardize system reliability of the status quo.


Consider a typical rate-making proceeding for a regulated utility. Electric utilities can recover all prudently incurred operating and maintenance costs plus an opportunity to earn a fair return on their investment. This process involves three steps: (1) determining the total amount of revenues (i.e., required revenues) that an electric utility needs; (2) allocating the total to individual customer groups (e.g., residential, commercial, and industrial customers); and (3) designing a rate structure for each customer group that allows the utility to recoup costs.

Required revenues are the sum of operation and maintenance expenses, depreciation, taxes, and a return on rate base. The rate base is the total amount of fixed capital used by the utility in producing, transmitting, and delivering electricity. The return on rate base is the weighted average cost of capital, including debt and equity sources.

Allocating required revenues to customer groups involves four steps: (1) categorizing customers into groups with similar characteristics (e.g., low-voltage customers); (2) functionalizing costs into those pertaining to production, transmission, distribution, and administration; (3) classifying functionally assigned costs into those attributable to the customer (e.g., metering costs), energy (e.g., amount of consumption), and capacity (e.g., instantaneous demand); and (4) allocating costs to customer groups. The result of this process is the allocation of all of a utility's revenue needs into customer groups. The number of groups depends on the characteristics of a utility's service territory.

Rates are then designed to recoup the revenues for each of the customer groups. Rates can be based on the amount of consumption or the type of service. Consumption-based rates are either flat, or increasing or decreasing in steps. Service-based rates depend on the type of service a utility offers its customer classes: firm rates, lifeline rates, interruptible rates, stanby rates, various incentive rates, or time-of-use rates.

The problems with this cost-of-service approach are the incentives and opportunities given to electric utilities. They are not the type of incentives that characterize an efficient market and that balance the additional risk of operating in an efficient market.

Industry restructuring advocates believe that a competitive market will create incentives to operate more efficiently and make better economic investments in utility plant and equipment. In contrast to a competitive market, cost-based ratemaking does not generally reward utilities with a higher return for making an especially good investment in plant and equipment, or penalize them for making an especially bad investment. The return that a utility earns on a highly successful investment is generally the same as its return on a less successful one. The opportunity to prosper—or, alternatively, to go bankrupt—is generally not part of this regulatory process.

In many cases, the regulators themselves distort the ratemaking process. Historically they have allowed or even encouraged utility investments that would not otherwise have been made in competitive markets.

Makers of public policy in the U.S. Department of Energy (DOE) and the Federal Energy Regulatory Commission (FERC) believe that industry restructuring will change these incentives and introduce more efficient practices and technologies in the industry. Proper pricing of electricity is one such change. Time-of-use (TOU) rates is one example. TOU rates vary over the course of a year: hour by hour, day by day, or season by season. They are theoretically appealing: Consumers who cause daily peaks bear the burden of paying higher costs during those periods. Likewise, consumers contributing to seasonal peaks—such as using air conditioners—bear the cost of building the capacity needed to meet the peaks. In practice, TOU pricing has proved effective in shaping load for electric utilities, reducing peak demand, and lowering production costs.

When initially adopted, TOU rates were based on projections of future costs by season, month, day, or hour. However, advances in metering and communications technology now afford utilities the ability to transmit prices to customers based on actual operating costs and to read meters in real time. This "real-time TOU pricing" is one of the most important aspects of many of the restructuring efforts to date. They can provide customers with direct access to the prices arising in competitive electric markets.

Under restructuring, customer exposure to market-based electric rates will broaden in other ways. Because deregulation allows customers to choose their own electric suppliers, potential suppliers are becoming more innovative in attracting customers. Although the Internet is in its infancy now, entrepreneurs are in the process of harnessing it for electricity sales. Some Internet companies are purchasing wholesale power from generating plants and reselling it to customers on the Net. Other companies are aggregators. They enlist customers on the Net and create buying pools from which they can extract lower prices from suppliers.

Restructuring will promote the introduction of other advanced technologies and practices as well. For example, the use of combined-cycle, gas turbine power plants are expected to proliferate under restructuring. These plants are generally more efficient and more environmentally benign than many fossil fuel plants currently in use.


Competition can promote efficiency and lower average prices for electricity. However, there is no guarantee that all customers will benefit equally from lower prices. Larger commercial and industrial customers generally have the wherewithal to obtain better rates in competitive markets than do smaller residential customers. Because of fewer options, low-income households are especially vulnerable to competitive markets for electricity.

Environmental and social benefits could also be jeopardized under restructuring. The elimination of integrated resource planning (IRP) is particularly of concern. In an IRP process, energy-efficiency programs and renewable-energy technologies "compete" with conventional generating plants for the resource investment expenditures of electric and gas utilities. The competition takes into account the environmental consequences of producing electricity from fossil fuels. At IRP's peak in the early 1990s, more than thirty-three states mandated the use of IRP processes. These mandates came from state legislation or from state regulatory commission orders.

As the electric industry undergoes reorganization, the retail price of electricity will be determined more and more in markets with the participation of multiple parties who do not themselves generate electricity. The "wires" portion of utilities that historically ran energy-efficiency programs argue that they are unfairly burdened by running these programs if their competitors are not also obligated to do so. Therefore, IRP processes are jeopardized in restructured electric markets. Without IRP, the environmental consequences of relying more on fossil fuels—and less on energy efficiency and renewables—are obvious.

Finally, a number of industry engineering experts and industry engineering organizations voiced concern that the electric grid may become less reliable after restructuring. The operation and maintenance of the North American electric grid depends on the coordinated interaction of more than a hundred control areas. The incentives to buy and sell power, retain adequate surplus capacity, and maintain the grid will change in a restructured electric industry. The reliability of the electric grid may suffer as a consequence.

Lawrence J. Hill

See also: Capital Investment Decisions; Eco-nomically Efficient Energy Choices; Economic Growth and Energy Consumption; Electric Power, System Protection, Control, and Monitoring of; Energy Management Control Systems; Government Intervention in Energy Markets; Subsidies and Energy Costs; Supply and Demand and Energy Prices; Utility Planning.


Fox-Penner, P. (1997). Electric Utility Restructuring: A Guide to the Competitive Era. Vienna, VA: Public Utilities Reports.

Phillips, C. F., Jr. (1993). The Regulation of Public Utilities. Arlington, VA: Public Utilities Reports.

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