How rates are set
What is a revenue requirement?
Before a utility can set rates, it has to answer one question: how much revenue does it need in the first place? That number is the revenue requirement, and everything else in ratemaking builds on it.
The short answer: the revenue requirement is the total amount of revenue a utility needs to collect over a period to cover its costs — operating expenses, depreciation, taxes where they apply, and a return on its investment. It is the starting point of every rate study: the cost-of-service study divides it among customer classes, and rate design collects it through actual charges.
The building blocks
A revenue requirement is the sum of a few components. A common way to express it:
RR = r × (Rate Base) + Expenses + Depreciation + Taxes
r = allowed rate of return · Rate Base = net plant + working capital
- Operating expenses — the day-to-day cost of running the utility: labor, maintenance, wholesale power, and administration.
- Depreciation — recovering the cost of long-lived plant (poles, substations, transformers) over its useful life.
- Taxes — where applicable; many cooperatives and municipals are largely tax-exempt.
- Return on investment — a return on the rate base so the utility can fund and finance the plant it uses to serve customers.
Not-for-profit vs. investor-owned
The "return" piece works differently by utility type. An investor-owned utility earns a commission-approved rate of return on its rate base. A cooperative or municipal utility is not-for-profit: its equivalent is the margin needed to fund growth, service debt, keep equity healthy, and meet lender coverage targets like a minimum TIER (times interest earned ratio) or debt service coverage. At a co-op, margins beyond what is needed are eventually returned to members as capital credits.
The test year
The revenue requirement is calculated for a defined twelve-month test year. It may be historical (recent actuals), historical adjusted for known and measurable changes, or a forecast future year. The choice matters: it sets which costs and how much energy the rates are built on, and it is often a point of scrutiny in a rate case.
Frequently asked questions
What goes into a revenue requirement?
Four broad pieces: operating expenses (labor, maintenance, wholesale power, administration), depreciation on plant, taxes where they apply, and a return on the utility's investment. For a regulated investor-owned utility, that return is the allowed rate of return on rate base. For a cooperative or municipal utility, it is the margin needed to stay financially healthy and satisfy lenders.
What is a test year?
A test year is the twelve-month period used as the basis for the revenue requirement. It can be historical (a recent actual year), adjusted for known and measurable changes, or fully forecast (a future test year). The choice matters because it determines which costs and sales volumes the rates are built on.
Do not-for-profit utilities earn a profit?
No. Cooperatives and municipal utilities are not-for-profit, so their 'return' is not profit for shareholders. It is the margin needed to fund system growth, service and retire debt, maintain healthy equity, and meet lender coverage requirements such as a minimum TIER or debt service coverage ratio. Any excess margin at a co-op is ultimately returned to members as capital credits.
How does the revenue requirement relate to my rates?
The revenue requirement is the total dollars the utility needs to collect. Rates are simply the mechanism for collecting it: the cost-of-service study divides the requirement among customer classes, and rate design turns each class's share into per-customer, per-kW, and per-kWh charges. If the revenue requirement rises, rates generally must rise to match it.
Keep reading
What is a cost-of-service study?
How the revenue requirement gets divided among customer classes.
How are electric rates set?
The full three-step process, start to finish.
Rate360 helps utilities build a defensible revenue requirement from their real financial and operating data. See the methodology