Two market structures: regulated vs. deregulated
The first thing to understand is that rate-setting works differently depending on your state's market structure.
Regulated markets
In regulated (monopoly) markets, your utility handles everything: generation, transmission, distribution, and customer service. They're the only game in town. Their rates are set through regulatory proceedings overseen by your state's public utility commission.
Most of the country operated this way until the 1990s. Many states (particularly in the South and West) still do. Florida, Georgia, and Colorado are examples of regulated markets.
In regulated markets, you pay whatever rate the commission approves. You can't shop for a different supplier because there isn't one.
Deregulated markets
In deregulated markets, generation was separated from delivery. Your utility still owns the wires and handles delivery (at regulated rates), but you can choose who supplies your electricity (at competitive rates).
Pennsylvania, Texas, Ohio, and parts of New York and Illinois are deregulated. In these markets, rate-setting involves both regulatory processes (for delivery) and market forces (for generation).
How utility rates are set: the rate case
Utility delivery rates (and generation rates in regulated markets) are determined through formal regulatory proceedings called rate cases.
The rate case process
- Filing: The utility files a rate case with the state commission, requesting a specific revenue increase and submitting detailed cost documentation
- Discovery: Commission staff, consumer advocates, and other intervenors review the filing and request additional information
- Hearings: Formal evidentiary hearings where parties present testimony and cross-examine witnesses
- Briefing: Parties file written arguments
- Decision: The commission issues a final order approving, modifying, or denying the rate request
This process typically takes 6-18 months. Major rate cases involve hundreds of pages of testimony and can be highly contentious.
Cost of service ratemaking
The traditional approach is cost-of-service ratemaking. The utility demonstrates its costs (operating expenses, depreciation, taxes, return on investment) and the commission sets rates to recover those costs.
The formula: Revenue Requirement = Operating Expenses + Depreciation + Taxes + (Rate Base × Allowed Return)
“Rate base” is the utility's investment in plant and equipment. “Allowed return” is the commission-approved profit margin (typically 8-11% on equity). This structure gives utilities an incentive to invest in infrastructure — they earn a return on it.
What utilities can and can't recover
Commissions scrutinize costs carefully. Utilities can generally recover:
- Prudent infrastructure investments
- Reasonable operating and maintenance costs
- Fuel costs (often through automatic adjustment clauses)
- Required environmental compliance costs
They may not be able to recover:
- Imprudent investments (power plants that were never needed)
- Excessive executive compensation
- Costs from negligence or mismanagement
- Political contributions or lobbying expenses
How wholesale electricity prices form
In much of the country, wholesale electricity prices are set through organized markets run by Regional Transmission Organizations (RTOs) like PJM, ERCOT, MISO, and ISO-NE. For a deeper dive into wholesale markets, see our dedicated guide.
Energy markets
RTOs run real-time markets where generators bid to supply electricity and loads bid to consume it. Prices clear every 5 minutes based on supply and demand. When demand is high or supply is tight, prices spike. When conditions are mild, prices drop.
These “locational marginal prices” (LMPs) vary across the grid based on transmission congestion. Power at a congested node costs more than power at a node with spare capacity.
Capacity markets
Separate from energy markets, capacity markets pay generators to be available — to have capacity ready even if they're not always running. This ensures enough generation exists to meet peak demand plus a reserve margin.
Capacity is procured years in advance through auctions. The clearing price becomes a cost that load-serving entities (utilities and suppliers) must pay. These costs flow through to retail rates.
Ancillary services
RTOs also procure ancillary services: frequency regulation, spinning reserves, and other products that keep the grid stable. These add to wholesale costs, though they're a smaller component than energy and capacity.
How retail suppliers set their rates
In deregulated markets, retail suppliers offer plans directly to customers. Understanding their economics helps you evaluate their offers.
Supplier cost components
A retail supplier's costs include:
- Wholesale energy: The cost of buying power in wholesale markets or through power purchase agreements
- Capacity obligations: Their share of capacity market costs based on customer load
- Transmission: Costs to move power across the grid
- Ancillary services: Grid reliability costs
- Renewable requirements: RECs or other compliance costs if required by state mandates
- Customer acquisition: Sales, marketing, enrollment
- Operations: Billing, customer service, compliance
- Risk management: Hedging against wholesale price volatility
Fixed vs. variable pricing
Suppliers offer fixed and variable rates that reflect different risk allocations:
- Fixed rates: The supplier locks in wholesale costs through hedges and passes a stable rate to customers. They bear the risk of wholesale price increases. They build a premium into fixed rates to cover this risk.
- Variable rates:The supplier passes through wholesale cost changes monthly. Customers bear the price risk. The supplier's margin may be lower because they're not hedging.
Competitive dynamics
Unlike utility rates, supplier rates aren't approved by regulators. Competition sets the price. If a supplier charges too much, customers switch to competitors. If they charge too little, they lose money and exit the market.
This means supplier margins are relatively thin — typically 0.5 to 1.5 cents per kWh above their costs. Competition forces efficiency.
Default service and Price to Compare
In deregulated markets, customers who don't choose a supplier receive “default service” at a rate set by regulators.
How default rates are set
Utilities procure default supply through competitive solicitations. They buy wholesale power for blocks of customers and pass through the cost (plus a small administration fee). This creates the “Price to Compare” — the benchmark against which supplier offers are measured.
Default rates typically update quarterly or semi-annually as procurement contracts roll over. They reflect wholesale market conditions with a lag.
Why default rates change
Because default supply is purchased periodically through competitive solicitations, rates change when new procurements occur. If wholesale prices rose since the last procurement, default rates increase. If they fell, default rates decrease.
Rate design: how costs become rates
Once the revenue requirement is set (for utilities) or costs are known (for suppliers), they must be translated into rate structures.
Volumetric rates (per kWh)
The simplest approach charges a flat rate per kWh consumed. Your bill is usage times rate. This is how most residential generation rates work.
Tiered rates
Some utilities use tiered rates where the first block of usage costs one rate and additional usage costs more (or less). This can encourage conservation or provide a low cost for basic needs.
Time-of-use rates
Time-of-use rates charge different amounts depending on when you use power. Peak hours cost more than off-peak. This reflects that electricity actually costs more to produce during high-demand periods.
Demand charges
Commercial rates often include demand charges based on peak kW draw. This allocates infrastructure costs to customers who need more capacity.
Fixed charges
Most rates include fixed monthly charges for customer service, meter reading, and grid connection. These don't vary with usage.
Frequently asked questions
Who sets electricity rates?
Multiple entities set different parts of your rate. State utility commissions approve utility delivery rates through rate cases. Wholesale markets (run by RTOs like PJM) determine generation costs through real-time auctions. In deregulated markets, retail suppliers set their own generation rates, though they're subject to market forces and consumer choice.
Why do electricity rates vary by location?
Rates vary because of different generation sources (coal, nuclear, gas, renewables have different costs), transmission infrastructure costs, local utility operating expenses, state regulatory policies, and market conditions. Even within the same state, different utility territories have different rates based on their specific cost structures.
How often do electricity rates change?
It depends on the rate component. Utility delivery rates typically change only after rate cases (every few years). Wholesale market prices change every 5 minutes. Retail supplier fixed rates stay constant during the contract term. Variable rates can change monthly or even more frequently. Default service rates typically update quarterly or semi-annually.
What is a utility rate case?
A rate case is the formal regulatory process where a utility requests permission to change its rates. The utility files detailed cost information, regulators and consumer advocates review it, public hearings may occur, and the commission issues a final order approving, denying, or modifying the request. The process can take 6-18 months.
How do electricity suppliers make money?
Retail suppliers buy power in wholesale markets or through contracts with generators. They sell to customers at retail rates that exceed their wholesale costs. Their margin must cover wholesale energy, capacity payments, transmission costs, customer acquisition, billing, regulatory compliance, risk management, and profit. Competitive pressure keeps margins relatively thin.
