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Paradox of Thrift

Economic barriers complicate T&D modernization.

Fortnightly Magazine - July 2009

principles ( e.g., simple-fixed-life, straight-line depreciation). Rather, regulatory depreciation practices in many jurisdictions have been (appropriately) designed to encourage utilities to realize the maximum practical technical and economic life out of any asset in the following way:

Depreciation rates are set periodically by defining the average service life (ASL) of each major asset class. The ASL is defined as the point where 50 percent of the assets of each type have survived (see Figure 4) . The ASL for all assets is periodically reevaluated at intervals that vary by jurisdiction. These methodologies follow the “Iowa” approach that dates from the 1930s. 1

A key implication of this approach is that if a utility removes a specific asset from service before its ASL, it loses the remaining depreciation. This under-recovery theoretically is rectified by that portion of the asset class that survives longer than the class average.

Fortunately, overall the industry’s depreciation practices haven’t necessarily led to bias of extending the service lives of assets. The long-run trends of the industry’s implied ASLs estimated from depreciation rates of distribution plant has been substantially flat (perhaps slightly declining) over a very long time period (see Figure 5) . This stability of the implied service lives of distribution plant is consistent with the historically stable technologies, stable regulation, and the long-lived nature of these assets.

Although the overall industry trends suggest relative stability of the implied ASLs (and thus stability of depreciation rates), a closer examination of individual companies and jurisdictions reveals some critical challenges for some key jurisdictions and individual utilities. For example, Figure 6 highlights the overall industry trends with an overlay of the average implied service lives for distribution assets in the States of New York, Pennsylvania, and Massachusetts. For example, the ASLs of Pennsylvania utilities are systematically much longer than industry averages and indeed are getting relatively worse. These findings affirm those of other observers; 2 these results also are similar for New York as they have been consistently at third and fourth quartile.

The high and frequently rising ASLs are related to low and declining depreciation rates. These low depreciation rates result in a relatively low level of depreciation embedded in current rates. These low levels of depreciation can result in a highly negative self-reinforcing pattern: Low depreciation rates result in low levels of reinvestment, which extend service lives, and further reduce depreciation rates.

The original causes of these trends are multifaceted: Some of the utilities struggled with low investment levels in earlier periods (for example, from nuclear- related crises) and others struggled under onerous rate caps that resulted from merger agreements or deregulation initiatives. At this point, they represent an onerous financial barrier to modernization without a clear expectation of significant future rate increases and periods of lower return between rate cases.

Future Depreciation Rates

While historic depreciation rates play a critical role in determining the investment resources that are available to fund any utility’s modernization initiatives, future depreciation rates will play an even more significant role in the pace of reinvestment and the economic return of the