what is rate base

What is Rate Base? Understand How Utilities Make Money

The financial term ‘rate base’ is typically misunderstood by investors. However, for people investing in utilities, it is essential to know. The rate base is unique to the regulated utility industry. It helps determine the amount of revenue a utility earns. The quantity is one of the two important metrics investors should learn.


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Rate Base Definition

A utility’s rate base is the value of assets on which a regulated utility may earn a stipulated rate of return. Specifically, the rate base is the property used to provide service to customers minus accumulated depreciation. Hence, it is an important metric. The exact components of the rate base depend on the industry and regulator. Regulators are known as Public Utility Commissions (PUCs); each state and some municipalities have one.

Electric utilities’ rate base is the value of generation, transmission, and distribution infrastructure. Gas utilities’ rate base is determined from the quantity of transmission and distribution lines. For water utilities, the rate base includes distribution pipes, water treatment plants, meters, and hydrants. However, many factors are considered in the rate base calculation, and the components differ in each state. But it is usually the firm’s weighted cost of capital.

Rate of Return

The rate base is important because it helps compute revenue. Regulators permit utilities to earn a rate of return in exchange for an exclusive right to sell a service in the state. The values generally range between 9% and 14%, depending on the state and specific utility. 

Revenue 

The rate of return and the rate base are the main components of the revenue formula.

\( Revenue = {(Allowed~Rate~of~Return)(Rate~Base) + Operating~Expenses} \\\)

Consequently, utilities can earn more by investing in infrastructure, resulting in a higher rate base. Alternatively, they can periodically request a high rate of return. Expenses are simply passed through to customers.

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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.

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