Retail rate development: the role of the cooperative board.

• Author: Hedrick, David, Sr.

No issue facing a cooperative board is more complex and yet more important than its oversight of the development of effective retail rate policies. No one likes to raise rates. And no one likes sitting in a dark board room staring at a glowing projection screen full of row after row of numbers.

Cooperative board members are no exception; yet they must gain a basic understanding of how proposed rates are developed. So how does today's cooperative manager determine the appropriate level of involvement by the board which enables effective decision making without an information overload that can lead to loss of understanding or even paralysis in the rate changing process?

Experience suggests the answer varies from system to system. However, given the potential impact on members, development of properly designed rates requires input from all disciplines within the cooperative, including: accounting, customer service, human resources, engineering, operations and management. As the policy setting entity and, in some states the rate setting entity, the board is well served to have a solid understanding of the breadth, if not the detailed financial intricacies of the issues. The board also serves as a key communications conduit between the cooperative and the membership.

Every board member at a cooperative implementing a rate increase has no doubt heard questions like these from the members they represent: "Why are you raising my rates?" "Why did you raise my customer charge instead of just the energy charge?" "Why did the rates for residential customers go up 5 percent while rates for irrigation customers went up 7 percent?" Trustees who understand industry trends and have a basic understanding of the rationale behind the rate design and the process of setting rates can more effectively answer these questions.

THE RATE CHANGE PROCESS

The rate change process generally begins as a result of any number of factors. They include:

* a recognized deterioration in the system's financial indicators

* a change in the wholesale cost of power

* response to competitive pressure

* response to a special contract rate request from a member

Whether the cooperative is conducting a complete review of its rates, developing a special contract rate or a proposed rate for a new rate class, the standard process of rate development is essentially the same.

Standing at the beginning of a rate design project and gazing out over the landscape of the information to be reviewed, analyzed and transformed into a meaningful report can be overwhelming. One way for a distribution cooperative board to "wrap its arms around" the process is to break it down into five distinct steps:

* Determine the overall system revenue requirement

* Develop the class revenue requirements (Cost of Service)

* Develop the individual customer revenue requirements (Rate Design)

* Coordinate the line extension policy with base rate design

* Monitor and analyze ongoing performance

The board's role in the rate analysis process is to balance two sometimes conflicting duties. This is an essential and often challenging role that cooperative directors must assume. The first duty is to meet the cooperative's financial objectives and maintain satisfactory financial ratios. The second duty is to minimize the impact of costs on members by providing the lowest reasonable rates. If rates are set too low, the cooperative risks not meeting lender mortgage requirements, experiencing decreased cash levels and declining equity levels. If rates are too high, the cooperative risks consumer unrest and uncompetitive rates. The task before the board is to balance these two competing objectives in determining the cooperative's overall revenue requirement.

DEVELOPMENT OF OVERALL REVENUE REQUIREMENT

The first step in the development of the overall system revenue requirement is determining the appropriate level of margin. The financial criteria required to define the level of margin is based on each individual board's objectives associated with:

* Equity Management Plan

* Capital Credit Refund Policy

* General Funds Level Objective

* Coverage Ratio Required by Lenders

There is a margin requirement associated with each criterion noted above. It is critical for the board to understand the relationship between these objectives when determining the overall revenue requirement. The board cannot focus on a single financial objective; it must consider all objectives and how they interact. For example, when considering the equity level established in the equity management plan, it is imperative that the board be mindful of the effect that equity level has on the overall revenue requirement. As investment in new plant increases, the required margin to maintain a specific equity percentage level also increases. If growth in plant is not also accompanied by a sufficient increase in sales it can be a real challenge to maintain the equity objective without an increase in rates. The equity objective also determines the level of debt to be incurred by the cooperative. This directly impacts the level of debt service payments which in turn affects the system's financial coverage ratios, In addition, the rotation of capital credits affects the level of cash reserves, which also affects equity levels and ultimately the cooperative's overall revenue requirement.

A capital planning model or financial forecast prepared by staff and management are valuable tools in the evaluation of the overall system revenue requirement. The results of these types of analyses enable the board to see the relationship between their financial goals and anticipated system performance as those goals are implemented during the next three to five years. The board should be presented with a clear view of the big picture with regard to the cooperative's financial objectives, how the system will achieve those objectives and how...