DOE/RGI

A Consumer's Guide totbe Economics of Electric UtilityRatemaking

NOTICEThis repon was prepared as an eccount of work sponsored by the United States Government. Neither the United States nor the United ttle Stat8$ States Department of Energy, nor any of their employees, makes any Stat8$ warranty, express or implied, or assumes any legal liability or ttle ecc:urac:y. ntSponsibility responsibility for the eccurecy. completeness, or usefulness of any information, apparatus. product, or process disclosed, or represents that its use would not infringe privately owned rights. Reference herein to any specific commercial product, process, or service by trade name, mark, manufllC1Urer, or otherwise, does not necessarily ~e, manufacturer, constitute or imply iu endorwment. recommendation, or favoring by endorwment, the United States Government or any agency thereof. The views and opinions of authors expressed herein do not necessarily state or Government egency reflect those of the United States Govarnment or any agency thereof.

Available from:National Technical Information Service (NTIS) U.S. Department of Commerce 5285 Port Royal Road Springfield, Virginia 22161 Price: Printed copy: M:icrofiche: Microfiche: $9.50 $4.00

I,'ul' SlIll' u.1" the XIII"'l"illlclIIS Wcx..F {]923} WoLF PACKING V. KANsAS Cl923) NEBBIA v. NEW YORK (1934)

RATES &EARNINGS S~ SERvICE SAFE'TYJ SeRvICE

AND PHD EFFICIENCY

~~fi1JRAL GAS ~~fi1JRAL GAs

V.

FPC

' 1; E;, .

BE ST~ED, ST~ED.

CoRP. FINANCE &INlERCORP. FIN.fcmLM'S

CE DISCRIMINATION CECcNrINOOUSLY

& REPORTS

GoALSINVESTORJ

DeMo.No PEAK DEMo.No f.u. CusTores '\sT SERVE fu. Cusrores

Cooslft:RJ CoosltERJ END IN VIEW 6aRAL. \' 6aRAL l'lELFAREJ

-43-

APPENDIX The long run average cost curve is a composite of the cost of operating various sizes of plants. If the cost per unitI I

"--' "-

decreases over the entire curve it looks like the one in FIGURE I-Abelow, and is said to reflect economies of scale* and hence decreasing cost, over its entire length. FIGURE I-A

Long Run Cost Per

KWH

Output or Quantity Demanded If the curve decreases and then increases it looks like the one in FIGURE 2-A and is said to reflect economies of scale (decreasing cost) up to pOint point A and diseconomies of scale

(i ncreasi ng cost) to the ri ght of poi nt A. the most efficient long run output for a plant.

Poi nt A represents

*One thing that is important to note at the outset is that economies of scale are a phenomenon that are unique to a firm, not an industry. But in the case of most electric utilities one company has a monopoly in an area. Therefore in these areas the firm is the industry and it is possible to discuss economies of scale within an industry context.

-44-

FIGURE 2-A----\I

Long Run Cost Per

KWH

Output or Quantity Demanded Those who argue that the electric utility industry is a decreasing cost industry mean that it experiences economies of scale over the entire range of its long run average cost curve. They would say that the cost curve for the industry is similar to the one in FTGURE 1-A. ("'. Those who argue that the industry is an

increasi ng cost industry mean that as output expands the average cost per unit increases. This includes the situation in which

cost per unit decreases for a time and then begins to increase. To those who hold this position, the cost curve for the electric utility industry looks like the one in FIGURE 2-A. Clear 1y, Clear1y, both arguments cannot be correct. There are two

possible explanations for an increase in the cost per kilowatt hour. First, the industry may have experienced growt\ to a point which has exhausted all of the economies of scale.,,~.his ,'".his case

one could argue that the industry had been on the decreasing porti on of the long run average cost curve, but now has had to build larger plants to keep up with demand and consequent.1y has

~\ ~.

moved to the

increasing portion of the cost curve.

This is

-45-

illustrated in FIGURE 3-A. plant size 1, then to

In this case the firm has moved from plant size 2. In both cases costI

decreased.

But when demand continued to increase a larger plant, If

"-

plant size 3, had to be built and cost per unit increased.

this argument is correct, it means that greater efficiency would occur if the industry had more firms operating with plant size 2. That is, this argument leads to a breakdown in the idea that

a natural monopoly exists in electricity generation. FIGURE 3-A

KWH

Long Run Cost Per

uOutput or Quantity Demanded second possibility is that the industry remains a but has experienced an increase in This means that the price of its inputs have This is

The

decreasing cost industry, absolute cost.

increased and caused the cost curve to shift upward. illustrated in FIGURE 4-A.

In this case the industry is still

experiencing decreasing cost as larger plants are built to meet increased demand. This means that cost curve Lad and Lac2 in

FIGURE 4-A have the same shape, both st ill havi ng economi es of i 11 scale. has All that has happened ;s that the absolute level of cost is and the cost curve shifted from posit i on 1 to position

increased

-46-

position 2.~II

It is true that plant size 2A has greater costs than

plant size 1, but this is due to increased absolute cost, not to exhaustion of economies of scale. FIGURE 4-A

KWH

Long Run Cost Per

~~e3Y_-~_:-':_~~,~_=-=-=-=-_-=-~:::...,..r::::::..

\

~~ ant"" } ant ""

Lac2

Lac1

_

Output or Quantity Demanded

c-\ ~\

This argument is important because the implications for policy are considerably different. If the industry has become

one of increasing cost the policy called for would be one which increased the number of firms, i.e. which provided competition instead of regulation in electricity generation. If it is still

a decreasing cost industry the policy would be one of continued regulation with closer supervision of costs.

-47-

CHAPTER

TWO

THE ANALYTICAL FRAMEWORK: AN OVERVIEWI~

INTRODUCTION As noted in the preceding chapter, regulatory commissions are confronted with the general task of bringing about the same economic privately results owned in the electric utilities utility (IOU's) industry have, a where

electric

complete

monopoly licensed by government that would naturally occur under competitive market structure conditions where there are "many" producers of a given product. 1 Specifically this means that a regulatory commission must strike a balance among the interests of the consumer, the investor, and the utility company, as well as those of the general public. Society at large may be

interested not only in efficient and non-wasteful allocation of resources, but may also be deeply concerned about inflation, and environmental problems. The consumer is

economic growth,

concerned directly with being forced to pay overcharges, while utility stockholders are concerned directly with obtaining a fair return on their financial investments. Salaries, pensions,

working conditions, etc. directly affect, utility: paid

for a utility company's

employees can

adversely or positively, the operation of a

this in turn, can adversely or positively affect prices and dividends received by stockholders. In

by consumers

lObviously industries that are characterized by competitive market structures (ll many" producers) are almost extinct in the ("many" industrial sector of the American economy.

-48-

actual

practice,

creating

a is

balance primarily

between

these

often through

conflicting

economic forces

accomplished

political considerations. As Professor Kahn, a noted utility economist, eloquently and apt ly states: Governmenta1 pri ce-fi xing is an act of pol it i ca1 Governmenta 1 ca 1 economy, and, it bears repeating, this means that it necessarily and quite properly involves the striking of a balance between conflicting economic interest, influenced by political considerations in both the crassest and the broadest possible senses, and informed by community standards of fairness. 2 It cannot be stated too often that public utility regulation is a political process. Justifiably or not, it is often widely

believed that powerful vested interest groups (for the most part large industrial concerns and the public utilities themselves) have('\ ( \

an

inordinate

amount

of

influence

over

the

regulatory

process.

Students of the electric utility industry say that "in

time" many, if not most, commissioners become "industry minded." Notwithstanding the political nature of the regulatory situation, most decisions made by commissioners concerning how much total revenue a utility should be allowed to collect for its services are justified through economic jargon - economic except a small select group of lawyers jargon that and few

economists

understand.

Thus in order to make the regulatory commissions its constituents, a clearer the utility industry is

responsible and accountable to all understanding of the economics. of

indispensible to

consumers and

consumer advocates.

In short, a

2Alfred E. Kahn, The Economics of Re ulation: Institutions, (New York: John Wiley & Sons, Inc., p. 42.

-49-

political process with only minority participation cannot be

'",-,

expected to be responsible to the majority.participation requires knowledge.

In turn, responsible

A consumer organization will

especially require knowledge of the economics of utilities, and familiarity with much of the jargon associated with it. This

chapter displays the basic economic framework of the electricutility industry.

Subsequent chapters discuss in more detail

each major component. THE ECONOMIC FRAMEWORK Electr ic util ity economi cs encompasses two basi c processes. First one must consider the total cost (TC) a utility incurs when providing the public with a service. Second, one must determine the rate structure or prices that

a utility must charge its customers in order to bring insufficient funds, total revenues (TR), to cover total cost. In

essence, the .regul atory commissi on attempts to equate total cost regulto total revenue. In equation form this would appear as:

1) TC

= TR

Total Cost

Total cost can be subdivided into two basic categories:total operating expenses (TOE) and total earnings (TE). Giving

c equat the basi cequat ion:2) In turn, TOE TC

= TOE

+ TE

consist

of

operation

expenses

(OE),

annual

depreciation (AD), and taxes (TX), such that:3) TOE

= OE

+ AD + TX

-50-

Historically TOE has run around 75 to 80 percent of total---\ I

cost.

Operat i on expenses may well account for 55-60 percent of

total cost; taxes for 5-10 percent, and annual depreciation for 10-15 percent. Contrary to conventional wisdom, it may not

always be in the' electric uti1ity's interest to hold cost down. As Clair Wilcox, a noted regulatory economist, says of operation expenses: Expenditures made on behalf of investors may be charged to consumers. Management may profit by voting themsel ves high sal aries and substanti al bonuses. a1 Holding companies may gain by forcing their subsidiaries to purchase goods and services at excessive prices. In some cases, the groups controlling regulated companies may be incompetent. In others they may be dishonest. To guard against such possibilities, expenses of operations must be supervised. 3 Operation expenses usually include such things as fuel, salaries, ('\\

advertising, litigation, public relations, income taxes, and net investment such as tax credit financial adjustments, as well as and engineering various expenses Obviously

consultants.

consumers are quite interested in how much of the price they pay for electricity, if any, is due to such items as inflated

salaries, wasteful advertising, and public relations. hand, it is easily recognizable that for

On the one to be

regulation

effective a utility must not be allowed to incur extravagant costs and then pass them on to its customers through increased prices. conmission On the other hand, a commission must allow a utility

operation large operati on expenses 1arge enough so as not to adversely affect the "service, safety and effi ciency" efficiency" util ity' s of the utility's operation.

3Clair Wilcox, Public Policies Toward Business, Illinois: Richard D. Irwin, Inc., 1966), p. 305.

(Homewood,

-51-

Students

of

electric

utility

economics

have

rarely

foundI

enforcement mechanisms for controlling total operation expenses to be overly vigorous. Total virtually enterprise. earnings the same (TE) in electric as profit utility economics mean to a non-regulated TE, then,\,,-. ,--.

thing

In essence, profit and TE are synonymous.

refers to the amount of dollars a utility is allowed to collect in order to compensate investors. The commi SS"j on determi nes the

amount of TE a utility will need by multiplying the value of the utility's property by a fair rate of return (ROR). represented by this equation: 4) TE This can be

= ROR(RB)

The rate base (RB) is often defi ned as lithe dollar value company's established by a regulatory commission of a companys plant, equipment and intangible capital used and useful in serving the public (minus accrued depreciation) on which the utility is\

,

I

\~

entitled to a reasonable rate of return. II II

In essence the rate

base is the estimated cost of a utility's productive properties minus any accrued depreciation. cost ll is referred to as "valuation. 1I IIvaluation.1I cost" The valuation process includes several major considerations, which can be briefly characterized as:A)

Establishing this

"estimated

Determining reproducible

which

properties

are

tangib le

and

B) C)

Determining which properties that a utility owns are used and useful in serving the public Determining which costing methods should be employed in assigning values - original cost, reproduction cost, value,. market value, etc.

-52-

D) E) F) G)

Determining whether to take cost data directly from a company's books, or by making an item by item appraisal Determining the proper amount of depreciation and subtracting this amount from the cost of the property Determining the value to be assigned to property that is tangible but not reproducible, such as land Determining the value to be assigned to property that is intangible, such as goodwill or franchise value

The value of an unregulated business is determined by the market. In other words, in the private sector the value of a

busi ness is whatever someone is wi 11 ing to pay for ownership rights. But in the public utility sector the commission creates Thus the utility

a utility's value primarily through determining costs. II va l ue "value problem ll problem" forms part of the core of public

regulation.

The commission should strike a balance between the

utility managers and investors, who quite naturally would profit

~.

from

an

inflated rate base,

and

consumers, who

should not be

forced to pay electric rates derived from an infl ated rate base due to improper valuation procedures. Equally important in determining total earnings (TE) is the rate of return (ROR). total earnings to The ROR can be defined as "the ratio of lithe a specified rate base, expressed as a

base." percentage of that base. 1I commissions often method. Suppose use what a

In establishing an

allowable ROR,

is called the "cost of capital" IIcost capital ll presented a commission with

utility

capitalization statistics as follows:

-53-

Capital Structure Bonds Preferred Stock Common Stock Total

Amount Outstanding $ 5,000,000 2,000,000 3,000,000 $10,000,000

Interest Rate

$ Cost $ 400,000 200,000 450,000 $1,050,000

8% 10% 15%

Here the utility is telling the commission that its cost of capital is $1,050,000. Assuming a rate base of $10 million, the

commission by granting the utility a 10.5 percent ROR would allow the utility to collect enough total earnings to pay the cost of invested capital. Establishing the proper ROR is a crucial As Professors Mosher and

factor in public utility regulation. Crawford have so succinctly stated:

If the return is too high, it will spell high rates to customers which may easily lead to market curtailment of use. Again, high return will facilitate the sale of securities that may result in the expansion of the industry over and beyond the normal requirements. Because of the consequent fixed charges, such overexpansion may then impose an intolerable burden on ratepayers . On the other hand, if the return is too low, there would be a dearth of capital requisite for the maintenance of proper service standards, deterioration of the property, and a lack of extensions called for by the normal expansion of the population. In the face of such possibilities, the determination of fair returns easily becomes a, if not the, major function of regulating bodies. 4 Here again the role of the commission should be to strike a ba 1ance between the vested i ntere st of investors, or pub 1i c utility managers, and of utility customers.

4William Mosher and Finla G. Crawford, Public Utility Regulation, (New York: Harper Brothers Publishers, 1933), p. 225.

u-54-

Combining equations 2, 3, and 4 we have: 5) TC

= RDR(RB)

+ DE + AD + TX

The first task of the regulatory commission in a rate proceeding is to determine the value and/or magnitude of the variables in equation five. Equation five is often called the "total revenue

requirement" since enough revenues must be collected to cover total cost: TC = TR.It follows then that if the TR collected

is to be large enough to cover TC, the TR requirement equation can be stated as follows: 6) TR

= RDR(RB)

+ DE + TX + AD

Total Revenue Unlike many businesses, electric utilities do not sell their product at a single price. An electric utility divides its

r

customers into classficiations and charges each class a different rate/price per kilowatt hour (KWH) of electricity. basic classifications are 1) residential, 3) industrial. Commercial customers are2)

The three and

commercial,

also referred to as

"Small Light and Power" customers while industrials are referredII Large Power II to as "Large Light and Power" customers.

To illustrate thi s

point, the average price per KWH of electricity charged these three customer classifications in 1976 was as follows: 5 Resi denti al Commerci al Industri al 3.45 per KWH 3.46 per KWH

2.D7 per KWHEdison Electric Edison Electric Institute, Institute,

5Statistical Committee of the Statistical Yearbook, (New York: 1977), p. 2.

("", r'-55-

groupings, In addition to price discrimination between customer groupings t electric utilities also provide "quantity discounts" within a II quantity discounts ll single customer group. For example t in a "declining block ll rate IIdeclining block" example, AI\.-

I\.-

structure, structure t quantity discounts are given for increased usage.

typical declining block rate structure for residential customers may look as follows: 0-100 KWH 101-300 KWH 301-500 KWH 501- ?KWH per per per per month month month month 5 4 3 1.5 per per per per KWH KWH KWH KWH

As shown in Table 1, page 58, due to price discrimination It 58 t between customer classes there is considerable difference between total usage and total revenues generated in each class. e, ex amp 1e t considering only these three basic For

customer

classifications, classifications t residential customers used 34.5 percent of the electricity generated but provided 41.1 percent of the total\

revenue; while industrial customers used 40.7 percent of the electricity revenue. generated Util ity but provided only 29.3 try to of the total price

\J

~ompanies ~ompanies

usually

defend

differences on the basis of differences in cost. prices should always reflect differences in cost.

course, Of course t

But utilities t utilities,

power, having monopoly market power t may attempt to charge higher prices where demand is strong and alternatives not readily available t available, and may charge lower prices where demand is relatively weak and alternatives readily available. Such price discrimination may be

economically justifiable if it can be shown that it lowers cost and prices for electric all customers possess as a whole. market Nonetheless, Nonetheless t power, power t if

utilities

monopoly

price

\0-56-

'\ \

discrimination may be an area of concern to commissions and consumers. The commission, then has two problems concerning the total revenue requirement. First, it must determine the absolute In electric utility

dollar amount of total revenues needed.

economics total revenue is often referred to as the rate level. As noted above, the commission establishes the rate level or total revenue requirement by ascertaining the utility's total cost of doing business. Second, the commission must determine

the amount of discrimination in prices that is economically justifiable. The actual KWH difference in prices between and

within customer classifications is known as the rate structure. CHART 1 on page 59 shows, in flow chart form, the

relationship between TR and TC as well, as the major components of ('\ , each. A glossary of terms structured to parallel the flow chart Used in conjunction with

is provided following Chapter Seven.

each other the flow chart and glossary may provide a helpful educational tool for better understanding the basic framework of electric utility economics.2)

Summarizing in equation form:

TC = TOE'+ TE TOE = OE + AD + TX TE = ROR(RB) TC = TR +OE TR = ROR(RB) + OE + AD + TX

Where 3) And If4)

1)

Then 6)

In subsequent chapters we will undertake a more detailed yet still quite brief discussion of total operating cost, the rate base, the rate of return and the rate structure.

-57-

TABLE 1 USAGE AND TOTAL REVENUE DATA BY CUSTOMER CLASSIFICATION IN THE ELECTRIC LIGHT AND POWER INDUSTRY, 1976

Customer Class Residential Commerc ial Industri a1 Total Source:

Usage Bil. KWH Percent613 441 725 1,779 34.5 24.8 40.7 100.0

Revenues $Bi 11i ons Percent21.1 15.2 15.0 51.3 41.1 29.6 29.3 100.0

U.S. Department of Commerce, The Statistical Abstract of the United States, (Washington, D.C.: U.S. Department of Commerce, 1978), p. 603.

..~

-58-

/J JCHART

~/) ~")

__J --)

1

lHE PNALYflCAL f1JLEL PNALYfI CAL fiJlll

~TE ~.AND (TR) OTPL NUE

.

. RATE STRUCTURE (RS)

I

CuSTO~R CLASSES

At.. 8RES IDENTI At. CeMv1ERCIALlLIGHT INDUSTRY CCMvlERCIALlLIGHT INDUSTRIAL

'fRJ,

,AVERAGES RATES

XQuANTITY

u

~

I

~1

Variations

from

the

straight-line

method

which

seek

increasingly greater

write-offs in earlier years of the useful

-69-

life of physical property are termed "liberalized depreciation."

Liberalized depreciation accounting conforms to certain approvedmethods of computing depreciation allowances for Federal and/or state income tax purposes, and is applicable to property with a useful life of three or more years. Two of the liberalized

I

',,\--

methods in practice for tax purposes are the sum-of-the-years

digits method and the declining balance method.Under

the

sum-of-the-years

di gi ts

method,

the

annual

deduction for depreciation is derived by multiplying the actual

cost of the property, less an estimated salvage value, by the estimated number of years of useful life remaining, then dividing the resulting product by the sum of all the digits corresponding to total years of estimated service.For a property with an

assumed life of 25 years, the sum of the digits would be (25 + 24+ 23 . . + 3 + 2 + 1)

= 325.

(A simple way to calculate this

\~

figure is to multiply the number of years by the number of years plus one and divide by two, i.e., (25 x 26) -i- 2 = 325. In year

number one the annual depreciation is 25/325ths of the cost less salvage value, while in year 25 the annual depreciation would be 1/325ths of that value.)Another method of liberalized depreciation accounting is the

declining balance method, statedas a fixed

in which the depreciation rate is(up

percentage

to

twice the

applicable

straight-line rate) per year, and the annual charge is derived by applying the rate to the net balance, determined by subtracting

the accumulated depreciation deduction of previous periods from the cost of the property.When

the property of any year is

-70-

almost fully depreciated, it is necessary to add to the reserve~\ I

the sma 11 amount requ i red to bri ng the reserve up to 100% of the retirement charges infinity. The amount of annual depreciation can vary considerably, The consumer value (actual cost in less salvage), or depreciation amounts to

would

continue

decreasingly

smaller

(dependi ng upon whi ch method the company chooses).

is affected by this depreciation charge in a number of ways. First, depreciation is a cost which the consumer pays in order to help insure that funds will equipment. rate base, Second, lowering be, available to replace worn out

depreciation charges are removed from the the total revenue requirements. Third,

depreciation is sometimes treated differently for tax purposes than for rate base purposes. These matters are discussed in more

detail in Chapter Four and Chapter Seven. TAXES As noted earlier, a pUblic utility is subject to several public categories of taxes. Some of these taxes are allowed to be

accounted for as a cost of doing business by commissions, while others are not. Typically, taxes such as sales, excise,

property, social security and franchise are allowed as "ordinary expenses of doing business." of these taxes are One problem may arise here. by state and local Most

1evi ed

government,

primarily by the state. dependent upon the tax

If, a given unit of government becomes revenues received from taxing pub 1ic

ut i 1iti es, that unit of government, knowing that these taxes are passed directly to a captive group of electricity consumers,

-71-'

might

push

the In might

taxes other

to

a level just be

not as

otherwise considered extravagant in TOE, costs so byI

equitable. management

words,

.,-

possibly

included

might

"extravagant" taxes.

Such taxes can cause an undue burden to be

placed on electricity consumers. To the extent that income taxes are cons i dered by

commissions as ordinary business expenses and hence included in TOE, regulated industry investors receive preferential

treatment.

In unregulated industries, income taxes are taken

from the total earnings of a company, after ordinary costs of doing business are accounted for. When income taxes are. treated as costs, an automatically increasing spiral is built into utility rates. Higher rates due

to taxes bring higher earnings, which bring higher taxes, which raise costs again. Further discussion of taxes Seven. The remainder of this is to be found chapter is in Chapter to , an

devoted

examination of court cases which have justified and defined the methods of allocating total operating costs. COURT CASES As noted at the beginning of this chapter, total operating expenses are an important i ngredi ent in the ratemak i ng process.It has also been noted that traditionally they have been solely

within the

purview of management,

and commissions

have

not

supervised the costs of utility companies.

However, since 1892,

the Supreme Court has recongized the right of commissions to supervise costs. In that year, in the case of Chicago and Grand,

\.J

-72-

Trunk Railway Co. v. Wellman, the court ruled that some provision~\

mu st be made to d isa 11 ow the practice of transferring earnings into operating expenses. The Court stated:

.~.\

It is agreed that the defendant's operating expenses were $2,404,516.54. Of what do these operating expenses consist? Are they made up partially of extravagant salaries: Fifty to one hundred thousand to p resi do 11 ars to the presi dent, and in 1ike proporti on to subordinate officers? Surely, before the courts are called upon to adjudge an act of the legislature fixing the maximum passenger rates for railroad companies to be unconstitutional . , they should be fully advised as to what is done with the receipts and earnings of the company; for if so advised, it might clearly appear that a prudent and honest management would, within the rates prescribed, secure to the bondholders their interest, and to the stockholders reasonable dividends. While the protection of vested rights of property is a supreme duty of the courts, it has not come to this, that the legislative power rests subservient to the discretion of any railroad corporation which may, by exorbitant and unreasonable salaries, or in some other improper way, transfer its earnings into what. it is pleased to call 'operating expenses. ' The Supreme Court has not consistently held this view. the booming 1920's the Court ordered During

.:-:

that operating expenses

could

not

be

questioned

by

commissions

except

in

extreme

circumstances.

In the case of Southwestern Bell Telephone Co. v.

Public Service Commission of Missouri, the Court held: The Commission is not the financial manager of the corporation and it is not empowered to substitute its judgment for that of the directors of the corporation; nor can it ignore items charged by the utility as operating expenses unless there is an abuse of discretion in that regard by the corporate officers.

This view made it practically impossible to control expensesresulting

from transactions between a parent company and itsIt also allowed nearly any 1I1ega111 expense to be "legal"

subsidiaries.

charged off to consumers.

-73-

Court, In 1930 the Supreme Court, mindful of a flood of criticism,began taking steps to reverse this view. Illinois Bell Co.

In the case of Smith y.

(1930), the Court ruled that the Illinois

Commission was empowered to reject costs incurred. via intrasystem incurred pur;chases of goods and services. The process of intrasystem

purchases involves a subsidiary buying from its parent company or from

another of the parents'I subsidiaries. parents

Since these areThe price

intrafirm transactions any price could be charged.

then becomes a cost to the subsidiary, and it is allowed torecover that cost in its rates. The parent company may be under

more or less strict regulation than some of its subsidiaries, and

depending upon the circumstances, may wish to show expenditures in one firm and revenues in another.The problem

is that

intrafirm transaction prices are not subject to competitive .J market forces, and if exempted from commission scrutiny, they a r e \:~ arenot regulated at all.

This process if allowed to function

provides the mechanism for a utility to escape practically all regulation of its rates. The Supreme Court expanded its revision to the Southwestern

Bell case in the case of Acker v. the United States (1936).

In

this case it ruled that the regulatory authority could reject

expend itures on the grounds that they were unwise.

Th is gave

much broader scope to control of costs by the commissions, and by

contradicted the view that costs

were

solely a matter

of

managerial judgment. As Justice Roberts said:Thecontenti on is that the amount to be expended for these purposes is purely a question of managerial judgment. But this overlooks the consideration that the charge is for a public service, and regulation

-74-

,

I I

''

cannot be frustrated by a requirement that the rate be made to compensate extravagant or unncessary costs for these or.any purposes. The courts have also been involved in delineating the scope of total operating expenses. In the case of Knoxvillev~ v.

Knoxville Water Co. (1909) the Supreme Court ruled that annaa1 annllal depreciation falls into the category of operating expenses. It

stated that the company is entitled to earn a sufficient amount to provide for the replacement of depreciable equipment when it comes to the end of its useful life. that current repairs on facilities Further, the Court ruled Court were to be included in

operati ng costs. In the Galveston Electric Co. v. Galveston case (1922) the Supreme Court held that taxes should be charged off as costs and

r:

that a utility was entitled to collect sufficient revenue from customers to COver these taxes. the elements of total It a1 so stated in a general way costs and why they were

operating

important.

In the Court's words:

In calculating whether the five-cent fare will yield a proper return, it is necessary to deduct from gross revenue the expenses and charges; and all taxes which would be payable if a fair return were earned are appropriate deductions. There is no difference in this respect between state and federal taxes or between income taxes and others. In other words, the Court ruled that the determination of a

proper return to the investor must allow the investor to recover all the expenses incurred, including taxes. ruling This rullng is the

basis for allowing income taxes to be treated as an operation expense, with all of the attendant difficulties.

-75-

This brief review of court cases indicates that the Supreme Court has established 1) two things concerning total operating

expenses:

the right of corrmissions to judge the wisdom and and 2) the

necessity of the expenditures of public utilities, general categories into which they are divided. have been somewhat lax in the first case,

The commissions

but have generally

followed the dictates of the courts in the categories of costs.

u-76-

CHART --\ GOALS AND OBJECTIVES t-9IVl.I\f\lAGErvENT AGEMENT kQUITABLE SALARIES TOTAL

1

OPERATIQ~ OPERATIQ~ EXPENSESCoURT Coun CASES ICAGO AND GRAND ICAGO RUNK RILROAD V, V. WELLMAN (1892)OUTHWESTERN BELL TELEPHONE V, PUBLIC V. SERVICE COMMISSI~ COMMISSI~ OF MISSOURI (1925)

~COVERY OF CoST

~SONABLE COST. PRIMARY ECONavtlC ELEt-'ENTS ECONOMIC ELEMENTSJAXONOMIC DESCRIPTION

NSUfvERS

~3a)V, ILLINOIS ~3a)V.

V('lTt1!; CKER V('lTtll; UNITED STATES 95b)OXY II,.,LE v KNOXYI LLE OXVII,.,LE V~I'\KNOXVILLE CO. (:100) ATER CO, (

kOE = (I + AD + TXPERATION ExPENSES (QE) NUAL DEPRECIATION AXES

19an

(AD)

CO. ALVESTON ELECTRIC CO, V, GALVESTON (922) V. (1922)

COO

, ME1HODS OF EVALUATIONOPERATION ExPENSES

ARMS-LENGTH BARGAINING ARITABLE CONTRIBUTIONS PUBLIC RELATIONS AND ADVERTISING ANNUAL DEPRECIATION

l,ACCOUNTING METHODSkTRAI GHT-LI NE

~IBERALIZED

JAXES

l+SALESJ ExCISE" PROPERTY" ETC, ~SALES" ExCISE J PROPERTY J ETC.

~INCOfvE ~INCOf'.

(STATE AND FEDERAL)-77-

CHAPTER FOUR INTRODUCTION

THE RATE BASE AS A COMPONENT OF TOTAL EARNINGS

In electric utility economics the total requirement is viewed as a' cost of doing business.

earnings

(TE)

In turn the

two basic components in establishing the TE requirement are the rate base (RB) and the rate of return (ROR). Koontz and Gable state: The formula most commonly used for arriving at reasonable earnings is to multiply a fair valuation of the property used and useful for publ ic service by a fair rate of return. Therefore, once a rate base has been determined, a regulatory commission must decide Ifair. 11 upon a rate of return that is 'fair. 11 This chapter contains a brief examination of the TE concept and the rate base as a component of the TE requirement. The ROR as a As Professors

component of the TE requirement is examined in Chapter Five. TOTAL EARNINGS As noted in Chapter Two, the total cost (TC) equation is stated as follows: 1) WHERE AND)-

= TOE + TE 2) TOE = OE + TX 3) TE = ROR(RB)TC

+ AD

Thus once total operating expenses (TOE) have been determined the problem becomes one of determining the TE requirement.

1Haro 1d Koontz and Richard W. Gable, Pub 1ic Contro 1 of Economi c Enterprise, (New York: McGraw Hill Company, Inc., 1956), p. 255.-78-

I

I

It is important not to confuse IE with total revenue,~\I'"

income or earned surplus. distinctions

In order to help make the basic consider the

between these terms more concise, following definitions: 2

TOTAL REVENUE (TR) - The actual dollar amounts a utility is authorized to collect from its customers. After subtracting total operating expenses from total revenue (TR - TOE), we get TOTAL EARNINGS (TE) - The actual dollar amount a utility is authorized to collect in order to pay the cost of invested capital (interest, stock dividends and incidental capital expenses). After paying all invested capital expenses except dividends on common stock, we get NET EARNINGS (NE) - The amount of actual dollars available for return to common stockholders as dividends or to be retained as earned surplus. DIVIDENDS - A portion of the amount of actual dollars available for return to stockholders and actually distributed to them in form of cash disbursements. EARNED SURPLUS (ES) - A porti on of the amount of actual do 11 ars ava il ab1e for return to common stockho 1ders not ab 1e 1ders actually distributed to them in the form of dividends but retained in the firm. This brings us to a somewhat confusing but crucially Actual total

important aspect of electric utility economics. earnings is the residual left over after doing business from total revenue (TR).

subtracting the cost of Viewed in this manner it

is easy to begin thinking that the size of a util ity' s TE is determined by the size of its TR. the case, that is, the But precisely the opposite is authorized to

amount of TR a utility is

2Francis X. Welch, Public Utility Regulation, (Washington, D.C.: Public Utilities Reports, Inc., 1961), p. 483. The definitions used as well as the format have been altered but the basic idea for this kind of representation was taken from Welch.

-79-

collect is itself determined by the commission. this can be shown as follows:

In equation form

IFAND THEN

4) 5) 6)

TR

= TC

TC = TOE + TE TR = TOE + TE

Thus the amount of TR a utility is authorized to collect is arri ved at by fi rst determi ni ng the TE requi rement and the TOE requirement. Nonetheless it follows algebraically from equation six that actual TE is computed as follows: 7)It

TE

= TR - TOE

is true 1) that algebraically TE equals TR minus TOE,

and 2) that from an accounting standpoint a utilitys actual TE are computed by subtracti ng TOE from TR;' but thi s must not be misunderstood as the method used by the regulatory commission in determining the actual dollar amount of TE a utility is

authorized to collect.

As stated, TE is viewed by the regulatory Once this cost

commission as a necessary cost of doing business.

is determined the utility is then authorized to collect enough TR to cover expenses incurred. On the one hand, if a utility's actual TE after subtracting utilitys TOE from TR are less than the TE authorized by the commission, the utility may seek to increase its TR by petitioning for a rate increase'. increase. On the other hand, utilitys if a utility's actual TE are

greater than the TE authorized by the commission, the commission may attempt to have the utility lower its rates, which will cause a drop in TR, which in turn will cause a decrease in actual TE.'.;

'\.J-80-

\

,

I

,

As already noted in Chapter Two,

in order to set the/'

appropriate TE requirement for a utility, regulators must 1) establ ish establish the net investment in the util ity, utility, thati~, '/the \/the/

utility's rate base (RB) and 2) determine what constitutes a fair and reasonable rate of return (ROR) on the rate base. A

utility's TE requirement can be shown in equation form as follows:8)

TE = ROR (RB) ( RB) and reasonable RB, a fair and

In establishing a fair

reasonabl e ROR and an appropri ate TE 1eve 1, the commi ssi on may attempt to strike a balance between the interest of the utility's investors, customers, and employees as well as the interest of the general public. For example, consumers are concerned that a

utility's RB not be inflated and that they be required to pay only for the actual cost of pl ant and equipment used and useful in providing them with service. utility's RB be an accurate Investors are concerned that a reflection of their capital

contribution and that the RB not be deflated or undervalued. Also, the ROR should be high enough to fairly compensate existing investors and all ON for the attracti on of new capital investment, but at the same time should be low enough to prevent the After establishing

extraction of monopoly profits from consumers.

a reasonabl e TE requirement by mul tiplying the doll ar val ue of the RB by the fair and reasonable ROR, a corrmissioncould allow for the collection of higher TE in order to retard economic growth, or, conversely, restrict TE in order to lessen the

adverse effects of a recession. authorize the collection of TE

In essence, a commission may lower or higher than the TE

-81-

requirement arrived at from applying equation eight above in order to promote or retard the use of electricity. PRIMARY ECONOMIC ELEMENTSl :

In rate base determinations, commissions seek to set a price for each of the individual items which collectively make up the rate base. These items are functionally divided into

physical plant (tangible and reproducible), intangibles, and land (tangible and non-reproducible). of ratemaking, includes Physical plant, in the context and equipment such as

machinery

generators, transformers, and utility poles. incidental costs, such as operating

Allowances called supplies,

materials,

prepayments, and working capital, are also generally included in th i s prim ar y economi c element of the rate base. 3 Another major determinant of the rate base's physical plant may be an allowance for construction work in progress (CWIP). the company's books which represents CWIP is an account on amount of the

the total

funds expended for a utility plant under construction, but not yet in service. This item mayor may not be included in the rate

base, but ultimately, when placed in service, it will become part plant of the physical pl ant . With most commissions today, the extent of CWIP's inclusion in the rate base has become a major issue in CWIP lsi nc1 usi on the determination of earnings. This issue is discussed in

Chapter Seven.

3For example, the Illinois Commerce Commission allows the inclusion in the rate base on a case by case basis of a 60-70 day by working supply of coal for use in the generation of electricity. /Conmonwealth Edison Co. has been allowed a 90-100 allowance. Commonwealth//

-82-

, Beyond physical pl ant, a utility system may have on its ant~ ,,-.,\ "-'\ books; booksi items which are not tangible but which have} monetary

valuel to the firm.

Such items iterns

'::';;'ns~nt ae~;~d "::';;'ns~nt

rights, licenses, privileges and other intangible property may be right$~ licenses~ i ncl uided in the rate base because ari acqui si ti on cost has been u;ded assoc!iated to it.Such items as goodwill and franchise values, values~

while. while! once included, are no longer included, since no actual cash included~ included~outl~

is directly associated, i.e., it has no cost of production associated~ i.e.~

to the firm.

Land, which may include land rights and leaseholds, i's Land~ leaseholds~ another item included in the rate base. anoth!erUnlike physical plant it

has no cost of producti on and generally increases steadily in production

val ue;.

The

latter one of

factor many

alone makesissues

the

timing its

of

its

l'. r

acqui~ition acqui~ition

concerning

accounting

treatlnent and inclusion in the rate base. the' trea~entselec~ively

It is, moreover, a

is~ moreover~though not

small

portion

of

the

rate

base, base~

an

incon1sequential amount in total dollars expended. inconSequential ECDNOMIC .PRINCIPLES EroNO~ICACTUAL COST'OF SERVICE

; Most commissions today use the actual money spent for commi ssi onsprimary economic

elements

in

determining the

total

cost

of

properties devoted to the public service.

The . result is that

these fi gures are 1arge ly removed from controversy, except for 1arge controversy~

questions of retroactive fairness.I

Some cormnissions, however, do cormnissions~ however~ In

val ue thes e propert i es at ot her than the actua 1 money out1ay. ue: properti actua1 out 1ay. any

:case,

regul atorson matters

must

necessarily

make

some

arbitrary and on

(~\

nct; di sti ncti ons

of inc 1usi ons 1 usi-83-

in the

rate base

arriving at a new rate base.

In other words, the relevant net

rate base (RB) for revenue requirement purposes is the estimated gross value (GV) of the util ity' s property used and useful minus accrued depreciation (D), that is RB = (GV - D). Gross value may \"--,,

be) found by adding up the values the commission finds for the primary economic elements included in the rate base. Accrued

depreciation then, is the sum total of depreciation attributable to these elements at the time of the rate base determination. 4

USED AND USEFULIn determining which items should be included in the rate base, commi ssi o.ns commissinns i ncl ude porti on necessarily include only that portion of the which are devoted to the current

primary economic elements operations of the company.

Thus, the rate base might exclude

such items as physical plant and equipment which has been or W i 1 1 0 will phYSical be purchased or sold, in the process of reclassification, leased to others, held for future use, or under construction. The

0

inclusion of property in the rate base should occur when the commission has made a critical review of the relevance of the costs before including them in the rate base. A determination by

a conmi ss ion in one proceed i ng that an i tern has been found "used II used and useful" does not mean that it will always remain so, or

preclude the issue from arising in following proceedings.

reasonab 1eness 4The reasonab1eness of a depreci ati on allowance for both operating expenses and net value of the rate base is still one of the most compl e~ and controversial problems of determining the rate base.

-84-

VALUATION METHODS In addition to determining which -items are to be included in the rate base, commi ssi ons set the val ue of those items as well. the Historically, conmissions have adopted methods which value primary economic elements so as to account for legal

interpretations,

as well

as to strike a balance between the In establishing the

interests of the producers and consumers.

value of the items included in the rate base, conmissions find themsel ves dealing with pl ant and equipment of various vi ntages: that is, plant and equipment of various ages and various

technologies, purchased with dollars of unequal buying power. Thus, a working knowledge of valuation methodologies is essential to a basic understanding of the rate base process. ORIGINAL COST The 1I 0riginal cost ll valuation method seeks to determine the lIoriginal costll actua 1 elements. actua 1 cash outl ay associ ated with the primary economi c lIoriginal Thus 1I 0riginal cost ll , sometimes referred to as the cos t ru 1e, 1e, sets va 1ue 1ue at the fi rm is actua 1 or II costll In practi ce, in applying the II ori gi nal cost ll

out-of-pocket cost.

method commissions- may vary the actual cost rule and therefore establish a compromised rate base. Variations or modifications

to actual cost valuation include historical cost--a cost of an asset committed to serving the public, having been incurred, is recorded as II a II matter of histo.ryll. (It is possibly the

IIprudent acquisition cost to the transferee company.) The term II pru dent investment ll cost refers to either an actual cost or a historical

-85-

r-

cost with the distinction that it be prudent I (neither obviously wasteful or dishonest). Basically, in applying the "original "or iginal cost" method most at actual cost.

commissions record plant and equipment costs Acquisition (historic) costs are also recorded. between acquisition cost and original

Any difference

cost are credited to a If the excess base, for

special account which is subject to depreciation. of acquisition cost were there included is in the a

rate

ratemaking

purposes,

still

question

regarding

amortization rates.

Thus, even with" an actual

cost rule and

arms-length bargaining, establishing the rate base is far from being a standardized process. Use of original costs, historical costs, or prudent

investment costs allow regulators to simplify the verification of accounti ng mi nimi ze records. mai ntenance These records are easi ly accuracy, understood, speed the

U

expenses,

improve

disposition of rate cases, make decision making more analytical, and provide uniform accounts for comparability. These factors in

turn insulate the utility from fluctuations in its records that result from general economic instability, reduce the risk to

investors, and promote investments in the util ity based upon a return on costs. account for changes Unfortunately, this method alone does not

in the value of money over time or for

inflationary pressures which result in a declining rate of return in terms of the value of money.

-86-

REPRODUCTION, FAIR VALUE, AND REPLACEMENT COST METHODOLOGIESWhen establishing the value of the rate base, regulators have adopted a variety of valuation methods which seem to account for i nfl ati onary pressures and the purchasi ng power of money over the years. While possibly accounting for these factors, the vast have adopted original cost

majority of regulatory commissions methods because of their simplicity. the value of other methods

Regulators generally feel

are outwei ghed by their resul ti ng consumers pay the expense, and the

expense and rate case delay:

delay may adversely affect the financial health of the utility. Regulators have relied upon the rate of return to account for such factors as inflationary pressures and the purchasing Thus a general understanding of some of the

power of money. basic terms will

suffice, unless one finds oneself in a state In

that applies something other than an original cost method.

that case, one must be prepared to unravel what is probably a unique method, and one that is difficult to quantify. Reproduction cost is the cost of duplicating the existing plant and equipment at current prices. variations. It has at least six main

Fair value is considered a composite measure which

considers accrued depreciation on actual cost, reproduction cost when new less depreciation, and other factors, each weighted

according to their effect on value.

Replacement cost prices old Historically, little to

plant at the price of a modern technology version. both the literature the often and the commissions in

have done The

distinguish

differences

these methods. used when

term fair to any

l ~.

value

has

been incorrectly

referring

-87-

or; g; methodology other than II ori gi na1

costll. cost".

comm; ss; Moreover, commi ssi ons

ll are still referred to as IIfair va1ue ll jurisdictions though some derivation of reproduction, replacement or fair value cost

methodologies are actually used. DEPRECIATION Determining depreciation as an element of the rate base process is a central utility may earn. issuei~

determining total revenues the

Since the allowance for depreciation impacts

on both the absolute size of the rate base and on total operating expenses, it is an extremely important issue. The proper

allowance for depreci ati on for the rate base's primary e1 ements is among the m,ost difficult problems of rate base determination. In practice, allowances for depreciation are both an accounting and an engineering matter. Therefore, accounting treatment

identifies this allowance as a cost, while engineering treabnent holds depreciation as a deduction to the remaining useful life of the primary economic element, which lessens its value to the firm. From' From- a blend of accounting convenience and engineering estimates, uti 1ity commi ssi ons make annual deducti ons to the rate 1ity base and recora these allONances into an accrued depreciation reserve account. This accrued depreci ation accounting for rate

\.J

base purposes allONS the utility to recoup capital investments in fixed assets in the form of a cash flow to the utility, i.e., an annual cost to the rate payer. Annual depreciation to the rate

base must therefore be considered a cost of doing business or an operati ng resulting expense. As a deducti on to the rate base, the

n.et net invesbnent (gross valuation - accrued

depreciation

-88-

reserve)~\

is the valuation figure upon which the investor is to a "fair and reasonable" rate of return. Net

entitled

invesbnent also represents costs to be recouped in the future from the customer over the remaining useful lives of the primary economic elements left in the rate base. As discussed in Chapter Three, the choice of alternative accounti ng methods with proper depreci ati on a11 owance vari es wi th a11 vari human judgment. These judgments ultimately seek to account for As

the allowance's effect upon the earnings of the utility.

belOlJ, illustrated in FIGURE 1 belOtJ, provisions for depreciation of the rate base fall into basically two categories--uniform annual

rates (straight-line) or variable annual rates (liberalized). FIGURE 1 Straight-line

~., ,

Depreciation Accounting Liberalized l--tSum-of-the-years L--.Declining balance The simplest and most usual procedure is called the

straight-line method.

Use of the straight-line method results in

a constant and uniform depreciation allowance rate applied to the rate base.It

is

often

claimed

that

variations

from

the

straight-line method more closely match the physical properties of depreciation. The physical property's use-value is then

assumed to decline faster in earlier years than in later years. Among (" l" those methods whi ch produce the hi ghest depreci ati on

allowance in earlier years

and lowest changes in the last years-89-

are the sum-of-the-years digits method and the declining balance depreci ca 1 methods (whi ch depreci ates physi ca1 property the fastest). It

should, however, be noted that reasonable data' to justify such high all (Mances is generally not avail abl e, and is uncertain at