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A Prescription for Regulatory Lag

Depreciation accounting methods can trim revenue shortfalls.

Fortnightly Magazine - April 2011

the utility, but rather through the simple passage of time and a utility’s obligation to serve.

The important fact is normal fixed asset replacement costs will cause a utility’s previous year’s depreciation expense, interest expense and equity balance to go up by the inflation rate 4 spanning the replaced asset’s lifetime. The rising depreciation, interest and equity generate a 67 ROE basis point drop. A 67 basis point drop is significant. An accumulating 67-point drop in ROE over several years quickly becomes very significant.

Alternatives to straight-line depreciation might provide solutions to the 67 basis-point degradation. One option is the sinking-fund depreciation method. 5 An important feature of sinking-fund depreciation is an interest rate to differentiate revenue requirements between return “on” and return “of.” Pretax capital cost from a utility’s rate case is an appropriate interest rate for a sinking-fund depreciation method. It employs the same equity- and debt-cost elements for depreciation as the ones driving the rate case’s net operating income. Hence, this sinking-fund depreciation method is referred to as pretax capital depreciation.

Pretax capital depreciation is very similar to a mortgage amortization. Return “on” can be compared to mortgage interest, and return “of” represents the reduction in mortgage principal as payments are made over time. The pretax capital cost rate represents the mortgage interest rate. Like a mortgage amortization, pretax capital depreciation’s return “of” (principal reduction) starts out small and grows larger in later years.

A first-year $2,500 fixed asset revenue requirement under pretax capital depreciation is $332 (versus $403 for straight-line depreciation). The $332 first-year revenue requirement contains a $7 return “of” (versus $83 for straight-line depreciation) and a corresponding $325 return “on” (versus $320 for straight-line). Figure 1 shows how straight-line depreciation peaks the fixed asset revenue requirement in the first year and how pretax capital depreciation creates a level $332 revenue requirement every year.

What pretax capital depreciation does is initially slow down depreciation recognition (versus straight-line depreciation). Slowing down depreciation creates higher net income and ROE. Also, in the next rate case, the utility’s rate base is larger due to less accumulated depreciation.

Figure 2 shows two straight-line examples and one pretax capital depreciation revenue requirement example. Column 1 has a utility that begins year one adding a $1,000 fixed asset. The utility adds a similar inflation adjusted amount each year for the next 30 years. At year 31 the initial $1,000 fixed asset addition is now $2,500. The first year straight-line revenue requirement for the $2,500 fixed asset is $403. The amount provided through existing rates is only $244 ($213 from depreciation and $31 from the retiring asset’s revenue requirement). The utility in column 1 has a $159 revenue shortfall ($403 minus $244), and that $159 shortfall equates to a 67 ROE basis-point drop.

Column 2 has a utility that also begins year one adding a $1,000 fixed asset. However, with no inflation, the utility adds the same amount each year for the next 30 years. The straight line depreciation revenue requirement for a $1,000 fixed asset is $161. The amount provided through existing rates