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A Prescription for Regulatory Lag

Depreciation accounting methods can trim revenue shortfalls.

Fortnightly Magazine - April 2011

is also $161 ($130 from depreciation and $31 from the retiring asset). The utility earns a 12 percent ROE in this unrealistic column 2.

The comparison between Figure 2’s columns 1 and 2 illustrates the impact inflation is having on a utility’s ability to earn its allowed ROE after exiting a rate case. Many regulatory frameworks are designed thinking the world operates like column 2 but, in reality the world works like the $159 shortfall in column 1. These regulatory frameworks ignore inflation’s certainty by assuming utilities can replace existing fixed assets without impacting their ability to earn their allowed ROE.

Column 3 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. Just as in column 1, the year one $1,000 fixed asset addition is now $2,500. The pretax capital depreciation revenue requirement for the $2,500 fixed asset is $332 annually. The amount provided through existing rates is $262. The utility in column 3 has only a $70 revenue shortfall. A straight-line depreciation utility (column 1) switching to pretax capital depreciation (column 3) can more than halve the ROE inflation impact shortfall (from $159 down to $70).

A utility with a three-year rate case mid-point can more than halve its 200 basis point impact (200 = 67 basis points per year for three years). Figure 1 shows how straight-line depreciation peaks the revenue requirement in the first year—at the worst possible time to try and earn an allowed ROE—and how pretax capital depreciation creates a level $332 revenue requirement.

However, pretax capital depreciation alone isn’t the answer.

Slowing Inflation’s Effect

Pretax capital depreciation’s strength is its initial slower depreciation recognition. But that’s also its weakness. By not recognizing depreciation as quickly as straight-line depreciation, it takes considerably more time to accumulate depreciation on the books. Without as much accumulated depreciation, a rate base grows larger, and a growing rate base requires additional external financing and rates to support it.

After a transitional period, a utility’s rates using pretax capital depreciation exclusively will be 8 percent higher than one using pretax capital depreciation for assets added between rate cases and straight-line depreciation thereafter. Straight-line depreciation’s strength is its ability to accumulate depreciation and reduce external financing needs. In the long-run, straight-line depreciation helps keep rates low.

To increase ROE by 100 basis points, pretax capital depreciation needs to be used only for assets added between rate cases. At the subsequent rate case, those assets on pretax capital depreciation would be switched to straight-line depreciation. The subsequent rate case’s new base rates would be built using straight-line depreciation for all fixed assets. This approach uses the strengths of both pretax capital depreciation and straight-line depreciation. The goal is to slow down inflation-impacted depreciation until it can be recognized in rates.

Pretax capital depreciation also can smooth out utility-earnings volatility associated with rate cases. The switch from pretax capital depreciation to straight-line depreciation increases depreciation expense at the same time new base rates are going into effect. Simultaneously