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An Indicator of Fairness

Ratable treatment of removal costs through depreciation should be favored.

Fortnightly Magazine - August 2009

and 60 years, 40-percent composite income-tax rate, 3-percent cost-escalation rate, 50/50 debt-to-equity ratio, 7-percent debt cost and liability discount rate, 11-percent equity cost, and external fund earnings after taxes and management fees that are 0.5 percentage points less than the after-tax cost of capital of 7.6 percent. The calculations are based on the half-year convention typically utilized for depreciation studies and depreciation-rate calculations, and ignore property taxes. Assumptions made to simplify the calculations are: a single asset, removal immediately upon retirement, tax depreciation equal to book depreciation, and deferral not increasing the risk reflected in the cost of capital (see Figure 3) .

The cost-of-service component for return and related income taxes in Figure 3 demonstrates the significance of rate-base regulation, because the return and taxes are the sole cause of the cost differences imposed on ratepayers, except for the External scenario. The rate bases for accrual of removal costs (Ratable, Escalate, and Liability scenarios) start at zero and eventually reach negative $1 as depreciation and accretion provisions accumulate over 40 and 60 years—Ratable on a straight-line and Escalate and Liability at ever increasing amounts. There are no rate bases for the External and Expense scenarios. The rates bases for the Amortize and Capitalize scenarios start at $1 and decrease to zero on a straight-line—amortize over five years; and capitalize over 40 and 60 years. The Ratable and Capitalize scenarios are shown to be the mirror image of each other, and the Escalate and Liability scenarios are shown to be so similar to each other that their positions on the list reverse when the life is 60 years.

A negative rate base produces negative return that is a credit for ratepayer-supplied capital, and a positive rate base produces positive return that is a charge for investor-supplied capital. The Ratable, Escalate, and Liability scenarios demonstrate that for long-lived assets the credit for ratepayer-supplied capital eventually overwhelms the annual effect of charging ratepayers for the removal cost amounts over the life of the related assets.

The six deferral scenarios can be thought of as forcing ratepayers to pay for removal costs multiple times. Each scenario charges for $1 of removal cost. Therefore, for a life of 40 years, Ratable can be viewed as charging for cost of removal once, Escalate and Liability as charging nearly twice, External as charging nearly three times, Expense and Amortize as charging more than three times, and Capitalize as charging more than four times.

These deferral scenarios do not exhaust the possibilities. For example, calculations are not made for present-value treatments other than SFAS 143 (a prepaid annuity), the most common of which is some form of sinking-fund depreciation, because there are too many ways sinking fund can be implemented for regulatory purposes. For sinking-fund depreciation, only the annual annuity amounts are considered as cost of service and the accumulations are not a deduction from rate base. For modified sinking-fund depreciation, both the annual annuity and interest amounts are considered as cost of service and the accumulations are a deduction from rate base. Therefore, the cost of service for