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A Prescription for Regulatory Lag

Depreciation accounting methods can trim revenue shortfalls.

Fortnightly Magazine - April 2011

What if utilities could earn an additional 100 ROE basis points using only their existing base rates? What if utilities are entitled to these additional 100 basis points but aren’t receiving them? This might sound too good to be true, but it isn’t.

Humans are creatures of habit. If something appears to be working, there’s little impetus to examine it further. However, recent developments are causing utilities to reconsider every aspect of their industry. The recent financial crisis, slowing customer growth, lower allowed ROE and increasing lag in base-rate filings are all affecting the bottom line.

Opportunities for improvement might be found in re-examining the way utilities initially recognize depreciation, and then use it in rate making. In particular, for assets acquired to serve customers while the utility is in-between rate cases, a pretax capital depreciation method would more accurately reflect the utility’s revenue requirement until those assets are incorporated into base rates.

Straight-Line Alternatives

Depreciation (also referred to as the return “of” capital) is inseparably linked with a utility’s return “on” rate base. ( See “Depreciation 101: ‘Of’ vs. ‘On’” ). An asset’s return “of” combined with the return “on” form the fixed-asset revenue requirement. Return “of” accumulates to build a deduction to rate base—the same rate base that drives the utility’s return “on.” Further, return “of” and return “on” represent material dollar amounts, comprising about half of a utility’s non-fuel revenue requirement.

In the following examples, capital cost is stated on a pre-income-tax basis for calculating rate making’s return “on” component. A pretax ROE is used to facilitate the fact ROE’s net income isn’t tax deductible. The pretax ROE is then weighted and combined with a weighted debt component to form the overall pretax capital cost.

A new utility that adds one customer each year will record 3.33 percent straight-line depreciation (assuming 30-year lives of assets acquired to serve customers). At the end of year 30 this utility exits a rate making process with a 12 percent ROE. 1 At the beginning of year 31 the utility implements its new base rates as its customer count plateaus. The first-year customer’s fixed-asset longevity matches the assets’ life expectancy. Those assets now need to be replaced—at current-dollar costs. To continue service, the utility must spend 2.5 times the amount it spent originally for this customer’s fixed assets. Since this customer-asset replacement wasn’t factored in the recent rate making process, the utility will earn 67 basis points 2,3 below the 12 percent allowed ROE.

Without another rate case the impact is cumulative; after another year and another customer replacement the ROE retrenchment doubles, and at the end of year three the ROE reduction is 200 basis points. The utility has no choice but to continue service to its existing customers. The utility has an obligation to serve, per its agreement with its state government. The lowered ROE comes via no direct managerial decision by

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