Prescription for Trouble?
In “A Prescription for Regulatory Lag” (April 2011), author Joe Rosebrock proposes and illustrates the use of sinking fund depreciation for new assets as a way to reduce the impact of regulatory lag. However, sinking fund depreciation has some problems, one of which is that it is prohibited by SFAS 92 Regulated Enterprises - Accounting for Phase-in Plans, (an amendment to SFAS 71, Accounting for the Effects of Certain Types of Regulation) from being utilized by enterprises that qualify for SFAS 71. SFAS 92 merely extends this prohibition to regulated enterprises, because sinking fund depreciation is prohibited for non-regulated enterprises by U.S. GAAP. Not being able to reflect Rosebrock’s proposal in financial statements would complicate things for any enterprise for which his proposal is adopted or imposed.
The article recognizes the existence of another problem—the deferral inherent in sinking-fund depreciation that inflates rate base, thereby increasing the cost for return on capital that is imposed on ratepayers over the lifetime of assets. This situation is evident from the relative areas of the two charts on Figure 1 of the article (p.16), which represent these costs. Inspection demonstrates that the area (cost) depicted by the “Pretax Capital Depreciation” (sinking fund) chart in Figure 1 is clearly larger than the area (cost) depicted by the “Straight-Line Depreciation” chart, which demonstrates that extra cost would be imposed by the deferral inherent in sinking fund depreciation. The cost shown by the “Pretax Capital Depreciation” chart calculates to be about one-third higher than for the “Straight-Line Depreciation” chart, and is solely due to the return on capital cost component, which is more than 50 percent higher than this component for the “Straight-Line Depreciation” chart. This doesn’t mean that Rosebrock’s proposal would increase the cost for return on capital by more than 50 percent, because his mechanism is intended to be in effect only from the time assets are placed into service until the next rate case.
While minimizing or eliminating regulatory lag is a commendable goal, the problems inherent in sinking fund depreciation might prevent Rosebrock’s proposal from being useful, but other mechanisms are available. Fair regulation can be expected to result in little or no regulatory lag through assuring that the cost of service reflected in authorized tariffs is consistent with the cost expected to be incurred during the period of time these tariffs are in effect. Mechanisms utilized for this purpose include forecast test periods, allowing construction work in progress (CWIP) in rate base, and tariff riders and adjustment clauses.
–John Ferguson, CDP Richardson, Texas
The Author Responds: I agree with Mr. Ferguson’s assessment that pretax capital depreciation may present itself with issues surrounding financial statement presentation. The costs necessary to implement pretax capital depreciation should be carefully weighed against its 100 basis-point add to returns on equity (ROE). I also agree with Ferguson’s point that pretax capital depreciation between rate cases increases revenue collected from utility customers. But pretax capital depreciation’s revenue differential is still only half the revenue necessary to allow a utility to earn its allowed rate of return—as demonstrated in the article’s Figure 2.
What is needed is a better understanding of the effectiveness of all the tools utilities and regulators have at their disposal to attack the 200 basis-point regulatory lag problem, including the tools suggested by Ferguson. My experience tells me pretax capital depreciation could offer significant advantages over previous alternatives. It’s for this reason I think pretax capital depreciation between rate cases should be added to the portfolio of possible solutions.
–Joe Rosebrock, Regulatory Affairs Vectren Corp.