In several recent utility rate cases, regulators have disallowed portions of utility compensation expenses, on the basis that difficult local economic conditions justify pay cuts. However, when...
21st Century ROEs: What Is Reasonable?
of average depreciation rates for utilities with a disproportionate share of distribution facilities may not match the range of average depreciation rates of utilities with a disproportionate share of production assets.
It is consequently important to compare proposed depreciation rates for similar types of assets. Figure 3 illustrates this point through the benchmarking of actual and proposed depreciation rates for the previously discussed utility's distribution assets. In fact, the discrepancy of proposed depreciation rates for distribution assets accounted for much of the dispute between the staff's and the company's depreciation witnesses. The figure shows that the company's pre-existing actual depreciation rate for distribution assets was close to the 75th percentile of depreciation rates for other U.S. utilities distribution assets. However, while the company witnesses recommended depreciation rate was close to the median depreciation rate of other utilities in the country (and, in fact, somewhat below the median), the staff's proposed depreciation rate for the company's distribution assets was well below the range of the depreciation rates that state regulatory commissions have allowed for other U.S. utilities' distribution systems.
Clearly, staff's depreciation methodology resulted in average depreciation rates that were below the depreciation rates this commission previously had allowed, and well below the mainstream of depreciation rates allowed by other state regulatory commissions for similar assets.
The adoption of the staff's depreciation methodology by the commission in a prior rate case triggered the discussed downgrade of the utility's credit rating from "A-" to "BBB" by S&P due to "low allowed ROEs" and "low plant depreciation allowances." In a subsequent case, the benchmarking of proposed depreciation rates as illustrated in Figures 2 and 3 highlighted the unreasonableness of staff's recommendation and resulted in a favorable settlement based on depreciation rates that were consistent with those of other utilities in the country.
However, as is the case with determining appropriate rates of return, the benchmarking of depreciation rates cannot be a substitute for detailed depreciation studies that appropriately take account of company-specific and industrywide trends and circumstances. These factors, such as trends in technical and economic obsolescence, are important considerations in the determination of appropriate forward-looking depreciation rates that maintain the utility's financial strength and access to capital. Credit rating agency concerns over low depreciation allowances also suggest that the low end of the observed depreciation rates may not represent adequate investment recovery.
In conclusion, while not a substitute for the proper determination of a company's cost of capital or depreciation rates, a comparison of experts' estimates relative to what has been allowed by commissions in the rest of the country can help regulators in their efforts to arrive at reasonable allowed returns and depreciation rates. However, this comparison of allowed returns and depreciation rates must recognize current concerns over low authorized returns, and it should not ignore industry trends, changes in financial market conditions, and unique circumstances of the individual utility.
Such benchmarking can help ensure that a utility's rates, including rates of return and depreciation rates, are set at levels sufficient to compensate investors fairly, allow for timely investment recovery, maintain a utility's