UMC Finance and Ratemaking 3 — Questions and Answers
Question 1: An inverted block rate structure is primarily designed to:
- Reward high-volume industrial customers with lower per-unit prices
- Encourage conservation by charging higher rates for greater usage (Correct answer)
- Eliminate fixed customer charges from the rate design
- Recover stranded costs from large commercial users
Correct answer: Encourage conservation by charging higher rates for greater usage
Inverted block rates charge progressively higher per-unit prices as usage increases, incentivizing conservation and penalizing excessive consumption.
Question 2: In utility capital structure, the 'optimal capital structure' balances debt and equity primarily to:
- Maximize the number of shareholders
- Minimize the overall weighted average cost of capital (WACC) (Correct answer)
- Achieve a debt ratio of exactly 50%
- Comply with FERC Form 1 reporting requirements
Correct answer: Minimize the overall weighted average cost of capital (WACC)
The optimal capital structure minimizes WACC by balancing the tax advantage of cheaper debt with the financial risk that too much debt creates, lowering the cost ratepayers ultimately bear.
Question 3: Under traditional rate-of-return regulation, if a utility earns above its authorized rate of return, regulators will typically:
- Allow the utility to retain all excess earnings as a performance bonus
- Order refunds to customers or reduce rates in the next rate case (Correct answer)
- Increase the authorized rate of return to match actual earnings
- Transfer excess earnings to a construction reserve fund
Correct answer: Order refunds to customers or reduce rates in the next rate case
When a utility over-earns, regulators may require customer refunds or use the finding to justify lower rates in the subsequent rate case to prevent excessive profits.
Question 4: The 'revenue decoupling' mechanism breaks the link between a utility's revenues and:
- Its authorized rate of return on equity
- Sales volume, removing the disincentive to promote energy efficiency (Correct answer)
- The regulatory asset base approved in the last rate case
- Customer growth projections used in the test year
Correct answer: Sales volume, removing the disincentive to promote energy efficiency
Revenue decoupling adjusts rates so utilities recover a fixed revenue per customer regardless of how much is sold, eliminating the financial incentive to maximize sales over efficiency.
Question 5: Which of the following is classified as an 'above-the-line' cost in utility ratemaking?
- Charitable donations not related to utility operations
- Income taxes on utility earnings
- Costs included in operating expenses within the revenue requirement (Correct answer)
- Earnings distributed to shareholders as dividends
Correct answer: Costs included in operating expenses within the revenue requirement
Above-the-line costs are operating and maintenance expenses recognized in the revenue requirement (income statement), while below-the-line items like dividends and charitable gifts are not recoverable from ratepayers.
Question 6: A regulatory commission uses the 'comparable earnings' method to set a utility's allowed return on equity (ROE) by referencing:
- The utility's own historical average ROE over the past decade
- Returns earned by companies with similar investment risk in competitive markets (Correct answer)
- The yield on 30-year U.S. Treasury bonds plus 300 basis points
- The average ROE of all regulated utilities in the same state
Correct answer: Returns earned by companies with similar investment risk in competitive markets
The comparable earnings method benchmarks the allowed ROE against returns that investors can earn in other investments of similar risk, ensuring the utility can attract capital.
Question 7: A 'rate case moratorium' agreed to in a utility settlement means the utility agrees to:
- Refund customers all earnings above the authorized ROE for a set period
- Not file for a rate increase for a specified number of years (Correct answer)
- Freeze its capital expenditure program until the next general rate case
- Abandon pending appeals of the commission's rate order
Correct answer: Not file for a rate increase for a specified number of years
A rate case moratorium is a settlement provision where the utility agrees not to file for higher rates for a defined period, giving customers rate stability in exchange for regulatory certainty.
UMC Finance and Ratemaking 3
An inverted block rate structure is primarily designed to: