How to benchmark return on equity (ROE) and depreciation expense in utility rate cases.
Johannes Pfeifenberger is a principal and Mark Jenkins is a research analyst at The Brattle Group, an economic and management consulting firm with offices in Cambridge, Mass., Washington, San Francisco, and London. The authors would like to thank Thomas Byrne, James Cook, Robert Cynkar, Alexis Maniatis, Kathleen McShane, William Stout, Steven Sullivan, Michael Vilbert, and Bente Villadsen for helpful discussions. Opinions expressed in this article, as well as any errors or omissions, are the authors’ alone.
Let's face it. Despite industry restructuring and the advent of alternatives to traditional cost-of-service regulation, the determination of allowed returns on utility investments still remains among the contentious tasks faced by many utility regulators. Opposing estimates of investors' required rates of return easily can translate into disagreements worth tens of millions of dollars in a utility's annual revenue requirement. Because disputes of similar magnitude can arise in determining appropriate depreciation rates, these two investment-related cost-of-service items-the return on investment and the recovery of investment-often represent the largest, most disputed policy issues in regulated utilities' rate cases.
The complexity of the subject areas-cost of capital and depreciation studies-also tends to present significant challenges for regulatory decision makers. However, allowed depreciation rates and rates of return have important implications for a utility's ability to finance needed infrastructure investments and ensure adequate and reliable service to their customers. A utility's ability to recover these two investment-related cost-of-service items is critical to its credit rating, which, in turn, is an indicator of the utility's cost and ability to access capital markets and fund needed infrastructure investments.
Unregulated industry participants have sharply curtailed their capital spending, and even regulated utilities have been struggling with severe financial pressures and an unprecedented industrywide credit crunch. As the NARUC president and EEI chairman pointed out in a joint statement: