"Water Rates: A Second Look"
As one who has worked in the regulatory environment for the last 23 years, certain accounting treatments deserve a second look to bring us back to basics. I raise the point because of an article I recently read by Dr. Janice A. Beecher and Dr. Patrick C. Mann, "Real Water Rates," published in the July 15, 1997 Public Utility Fortnightly (p. 42). At the outset, allow me to say that the opinion expressed is my own and does not represent the official position of the Delaware Public Service Commission.
In the portion of Dr. Beecher's and Dr. Mann's article headed, "Utility Spending and Historical Underpricing," they point to the causes for the historical underpricing for water services. According to the authors, one of those causes may be attributed to "failure to create depreciation reserves adequate to finance inevitable system replacement." This is an issue contested often both here in the Delaware regulatory jurisdiction and in other jurisdictions. The booking of depreciation does not have as its basis the formation of a reserve of cash or other liquid assets necessary to replace a capital asset.
According to Section 6.03, "Purpose of Book Depreciation Accounting" of the publication Accounting for Public Utilities: "In simple terms, book depreciation is merely the recognition in financial statements that physical assets are consumed while providing a service or a product. Remember that book depreciation is provided for recovering the original investment in the assets concerned, and not for providing for their replacement."
Although some involved in the ratemaking process may argue that the cash flow generated by depreciation is necessary to finance current construction needs, clearly booking of depreciation expense and subsequent aggregation of accumulation depreciation are not performed to finance replacement of the assets against which they are booked. It is not the role of ratepayers to finance capital improvements through the depreciation process; rather these funds are, and should be, provided by investors.
There are sound reasons why depreciation is not designed for this purpose. The primary reason is the fact that foreseeing the future is impossible as it relates to building and equipment needs for a utility. As sound as a utility's long-term capital plan may be, innovations in equipment may dictate that an entirely different type of equipment is the most efficient way to serve the customers. The price of the new type of equipment or even the same equipment, because of inflation, is undoubtedly going to be different from the price of the equipment being replaced.
Although I do not disagree with Dr. Beecher's and Dr. Mann's basic premise that there have been instances of historical underpricing in the water industry, one must be aware that there are instances where even with inappropriate depreciation rates, the retention of those rates will not affect the company's earnings. As the public advocate (and her consultant Ms. Andrea C. Crane of the Columbia Group) for the state of Delaware has recently observed: "Investors are compensated for the time value of money through a return on the Company's net utility plant in service. Therefore, investors are neutral from a net present value perspective between receiving the return of their capital more quickly, through higher depreciation charges, or receiving the return of their capital over a longer time period. As long as the net present value discount rate equals the investor's cost of capital, from a net present value perspective, the depreciation rates used by the Company are irrelevant."
I trust that the explanation provided will shed light on the depreciation process, but not be misconstrued as a criticism of Dr. Beecher's and Dr. Mann's very informative and sound article.
William C. Schaffer
Public Utility Analyst
Delaware Public Service Commission
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