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An Indicator of Fairness

Ratable treatment of removal costs through depreciation should be favored.

Fortnightly Magazine - August 2009

Rate-base regulation causes depreciation to be reflected in cost of service both annually and cumulatively—annually through the depreciation expense component and cumulatively through the return and related income taxes component as the annual depreciation expenses accumulate in the book reserve. The cumulative component eventually overwhelms the annual component, thereby causing the initial impact of any depreciation change to reverse in just a few years. This reversal allows the treatment of depreciation (especially the removal cost component) to demonstrate whether regulation emphasizes the near-term or the long-term, thereby providing a basis for judging its fairness.

Removal cost is the expenditure involved with physical removal or safe abandonment of an asset, and is not a trivial matter, because it is not unusual for such expenditures for long-lived property to exceed the related depreciable investment amounts. Those emphasizing the near-term favor removal-cost deferral mechanisms that shift recording and recovery to future ratepayers—a process that increases the costs to be borne by ratepayers through two influences. One influence is the resulting rate-base inflation that increases the total cost of service ratepayers will bear over the life of the assets. The other influence is the inherent increase in regulatory risk, which increases the cost of capital.

The ratable (accrual) treatment of removal costs through depreciation for regulatory accounting purposes has a long history, but is challenged periodically by proposals to defer its recording and recovery. Such challenges also have a long history, but have taken on renewed vigor as a consequence of FASB Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations (SFAS 143) issued in 2001.

Various treatments of removal costs have various effects on utility ratepayers. Of all the approaches the industry uses, ratable treatment through depreciation minimizes the costs borne by ratepayers.

Growth and Cost Escalation

Challenges to ratable treatment of removal costs through depreciation tend to emphasize the fact that the annual amounts reflected in depreciation rates typically exceed the annual expenditures for removal or abandonment. There is nothing sinister about this situation, as it is the natural consequence of the accrual accounting that is specified by the FERC electric and natural gas Uniform Systems of Accounts and of the existence of growth and cost escalation. However, it has led some regulators to dictate deferral mechanisms for removal costs.

To illustrate the influence of growth and cost escalation, think of retirement dispersion in the form of frequency patterns, such as those seen in Iowa-type curves (see Figure 1) . Consider a property group for which there is no growth or cost escalation, and for which the life is constant and described by the S3 dispersion pattern. The average monetary age of retirements climbs the frequency curve as the property group ages—eventually reaching

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