(October 2009) In his article “Paradox of Thrift, author James M. Seibert looks to be calculating his average service lives as the reciprocal of depreciation rates, whereas utility...
Letters to the Editor
and gas-utility property typically remains in service for much longer than 10 years, so there is plenty of time for the negative revenue requirement component to dominate, thereby causing the regulatory treatment of depreciation to be a “pay-me-now or pay-me-later” situation. The pay-me-later option is quite expensive for ratepayers.
Scott Gawlicki highlights this situation in his November 2007 article, “ Iatan 2: A New Coal Model ,” addressing an experimental regulatory plan concerning pre-approval of Iatan 2, a proposed coal-fired generating unit to be operated and partially owned by the Kansas City Power & Light Co. (KCP&L). An aspect of the plan ensures that KCP&L can maintain the financial ratios expected for an investment-grade bond rating, which is accomplished through accelerating the recording and recovery of depreciation. Gawlicki quotes a KCP&L officer on the benefit of the “pay-me-now or pay-me-later” concept:
We’re increasing rates and accelerating the depreciation of the assets. Accelerating the depreciation—in a sense paying more up front now—will result in lower rates later on. While the approach benefits the company in the short run, our customers benefit in the long run.
Gawlicki states that KCP&L agreed to reduce its return on equity for calculating the allowance for funds used during construction (AFUDC) from 10.8 percent to 8.3 percent in exchange for pre-approval of the unit. AFUDC is the mechanism through which regulated entities record the cost of financing a long-term construction project as a component of the construction cost for recovery from ratepayers over the depreciable life of the constructed facilities. Inclusion of an equity component in the financing costs is limited to entities that qualify for the special accounting allowed by SFAS 71, Accounting for the Effects of Certain Types of Regulation.
An alternative approach for dealing with project-financing costs is to charge them to ratepayers during the period of construction, which is typically accomplished by including construction-work-in-progress (CWIP) in ratebase. However, Missouri legislation prohibits electric utilities from including CWIP in ratebase. This CWIP treatment is not prohibited in Missouri for other types of utilities and for telecommunications companies, but I understand that the commission’s practice is to not do so.
The lower AFUDC rate will decrease the amount of financing cost that would otherwise be added to the Iatan 2 investment. It is unfortunate that the costs of financing cannot be paid by ratepayers over the period of construction, because ratepayers benefit from doing so. For example, my guess is that ratepayers would save $2 or $3 of return and related income taxes for every dollar of financing cost paid over the period of construction of Iatan 2. As is evident from this discussion, the “pay-me-now or pay-me-later” situation is just as significant to ratepayers when dealing with financing costs as it is when dealing with depreciation.
The ratepayer benefit from paying for financing costs over the period of construction is a consequence of the inflated ratebase resulting from capitalizing AFUDC. Sophisticated investors realize that capitalizing AFUDC increases income by a like amount, and consider this income to not be real. Other investors are unlikely to realize