Electric Rates Undercharge Monthly Customer Charges and kW Demand Charges

The monthly residential electric bill consists of a customer charge and a kWh charge. The monthly bill for a large power user consists of a kW charge and a kWh charge. Would it surprise you to learn it costs two to four times more to serve a customer with kW and customer services than what is included in the customer's monthly flat charge?

The undercharged kW and customer cost amounts end up embedded in the kWh charge. Why is this, why does it matter, and what might you do about it? Here are some schools of thought on electric ratemaking.

The Process for Making Electric Rates

In developing electric rates, a co-op or utility uses a three-step process :

1. Develop a revenue requirement — the amount of revenues needed from electric rates in the next budget period to operate the co-op or utility, including all expenses and regulatory items (GASB 62) and other overheads.
2. Perform a cost of service study — which allocates demand (kW), usage (kWh), and customer costs based on each customer class's usage pattern.
3. Design electric rates — that provide revenues equal to the revenue requirement.

The costs allocated in the cost of service study fall into three main types:

Trends in Electric Rate Theory

There are decades of embedded politics and strives for "equity" in any electric co-op or utility rate structure. The electric industry went through a period where industrial customers subsidized residential rates to keep residential customers out of rate hearings. Then there was a period where residential customers subsidized industrial rates to attract and retain industries in the community. Neither approach is inherently good or bad — they simply reflect the strategy of the time.

The move in recent years has been to move rates in each customer class toward the actual cost to serve them. But within each customer class, there is an internal inequity between the fixed monthly customer charge and the per-kWh variable charge. Addressing this is the essence of cost-based rate design.

Typical Cost Structure of an Electric Residential Customer

A cost of service study breaks down the monthly fixed cost to serve a residential customer across three components. The following table illustrates the typical structure:

Typical Residential Customer Electric Bill Components

Despite the actual cost to serve a residential customer being $50–$75 per month, the rate structure at most utilities places only a fraction of that in the fixed monthly customer charge:

Why Is Only a Portion of the Fixed Cost Being Recovered?

The cost pot for each customer class is fixed — all costs must be accounted for in customer rates. This means that remaining fixed costs end up in the volume charge. The risk in this rate design is that if kWh sales decline — due to economic conditions, technology changes, distributed energy resources , or population shifts — kWh revenues decline along with them.

Part of that revenue decline will not impact financial results because as kWh's decline, so does power expense. But a portion of the $/kWh is designed to contribute toward the recovery of fixed costs. So as kWh sales decline, there is less revenue available to cover fixed infrastructure — which does not decline.

Average Fixed Costs to Serve vs. Fixed Costs in Monthly Customer Charge

Demand charges are similarly "undercharged." Under-recovery of fixed demand costs creates financial risk for a utility or co-op if load patterns change or large customers exit the system. Demand charges are priced at an average of $10–$20/kW, where the actual fixed cost should be closer to $45–$60/kW. This puts the utility at risk of under-recovering fixed costs if kWh sales decline — as they did during the 2008–2009 recession and the brief recession of 2020.

Strategies to Close the Cost of Service and Rate Gap

Strategies for closing this gap range from moving immediately to cost-based fixed charges to maintaining the status quo, with a phased approach in between. An approach that has worked well in practice:

• Move in significant steps toward cost of service with each rate change. If the overall rate increase needed is 2%, increase the customer fixed charge by 10% while holding the volume charge increase to a smaller percentage.
• Communicate clearly with ratepayers. Moving the customer charge from $18 to $23/month typically draws more feedback than moving the per-kWh rate from $0.10 to $0.12 — even though the dollar impact may be similar. Transparency helps manage the transition.
•  Consider time-of-use rates  as part of a broader restructuring that better aligns rate components with actual cost causation.

If you also provide water and wastewater services, undercharging demand costs is equally common in those sectors and bears review alongside your electric rate structure.

The material in this article is for informational purposes only and should not be taken as legal or accounting advice provided by Utility Accounting & Rates Specialists, LLC. You should seek formal advice on this topic from your accounting or legal advisor.