Transcript Capital Recovery

Smart Grid: Capital Recovery
Branko Terzic, P.E., Sc.D. (h.c)
Executive Director, Deloitte Center for Energy Solutions
Regulatory Policy Leader, Energy & Resources, Deloitte Services LP
University of Texas Interdisciplinary Energy Conference
April 7-8, 2011
Revenue Requirement
O and M Expense $ (labor, materials, fuel)
+ Depreciation $ (% per year x $ rate base)
+ Taxes $ (Income, franchise, sales etc)
+ Return $ (% x $ OCLD rate base)
____________________________________
= Annual Revenue Requirement
Copyright © 2011 Deloitte Development LLC. All rights reserved.
2
Earliest Principles
 “It has become a judicial commonplace that a company is
entitled to charge rates sufficient to cover operating
expenses, depreciation, and “a fair return” on the “value” (or
on the “fair value,” as it is sometimes phrased) of its
property.”
– 1911 Electric Rates
Copyright © 2011 Deloitte Development LLC. All rights reserved.
3
U.S. Supreme Court Recognition of Depreciation
 Broadly speaking, depreciation is the loss, not restored by
current maintenance, which is due to all the factors causing
the ultimate retirements of the property. These factors
embrace wear and tear, decay, inadequacy and
obsolescence. Annual depreciation is the loss which takes
place in a year.[1]
[1] Introduction to Depreciation and Net Salvage of Public Utility Plant
and Plant of Other Industries, Edison Electric Institute, May 2003, p. 5.
Copyright © 2011 Deloitte Development LLC. All rights reserved.
4
Interstate Commerce Commission Definition
 The Depreciation is the loss in service value not restored by
current maintenance and incurred in connection with the
consumption or prospective retirement of property in the
course of service from causes against which the carrier is
not protected by insurance, which are known to be in current
operation, and whose effect can be forecast with a
reasonable approach to accuracy.[1]
[1] 177 ICC 351, 422 (1931), 14700 Depreciation Charges of Telephone
Companies, 15100 Depreciation Charges of Steam Railroad
Companies.
Copyright © 2011 Deloitte Development LLC. All rights reserved.
5
GAAP (“AICPA”) Accounting Terminology Bulletin No. 1
 Depreciation accounting is a system of accounting which
aims to distribute the cost or other basic value of tangible
capital assets, less salvage (if any), over the estimated
useful life of the unit (which may be a group of assets) in a
systematic and rational manner. It is a process of allocation,
not of valuation. Depreciation for the year is the portion of
the total charge under such a system that is allocated to the
year.
Copyright © 2011 Deloitte Development LLC. All rights reserved.
6
Causes of Depreciation

Physical
–
–
–

Wear and Tear
Decay
Action of the Elements
Functional
–
–
–
–
–
Inadequacy
Obsolescence
Changes in the Art and
Technology
Changes in Demand
Requirements of Public
Authorities
Copyright © 2011 Deloitte Development LLC. All rights reserved.
7
Principles of Public Utility Rates James Bonbright
 “extraordinary obsolescence should be considered when
evaluating appropriate service lives:
 In regulation, the allowances for depreciation both as operating
expenses and as deductible reserves are designed to cover
functional depreciation including obsolescence and not merely
physical deterioration or wear and tear. Hence the allowances
must be based on estimates or plausible assumptions as to the
effect of obsolescence on useful-life expectancies. But neither a
corporate management nor a commission can hope accurately to
predict, years in advance of the event, dates as of which old
properties may need to be retired for reasons of “extraordinary
obsolescence”.[1]
[1] Principles of Public Utility Rates; Bonbright, Danielsen and Kamerchen,
Public Utilities Reports, Inc., second addition, March 1988, First Printing, 1961,
p. 282-283.
Copyright © 2011 Deloitte Development LLC. All rights reserved.
8
The Regulatory Problem
 Longer lives lead to lower depreciation expenses!!!
 Annual %= 100% -Salvage +Cost of Removal
Average Service Life (years)
6%/year = 100% - 10% + 30%
20 years
3%/year = 100% - 10% + 30%
40 years
Copyright © 2011 Deloitte Development LLC. All rights reserved.
9
Management Responsibility
 The Estimation of Depreciation states that:
 Capital recovery is the responsibility of management. In
regulated industries management includes both corporate
and commission management. Each has a particular
interest in proper determination of depreciation, and
should have the well-being of the utility industry as a
major concern. [1]
[1] Ibid.
Copyright © 2011 Deloitte Development LLC. All rights reserved.
10
Factors in Estimation of Life
 Observable trends reflected in historical data;
 Potential changes in the type of property installed;
 Changes in the physical environment;
 Changes in management requirements;
 Changes in government requirements; and
 Obsolescence due to the introduction of new
technologies.[1]
[1] Public Utility Depreciation Practices, NARUC, August 1996, p. 129
Copyright © 2011 Deloitte Development LLC. All rights reserved.
11
Regulatory Issue
 Charles A. Zielinski, former Chairman of the New York
Public Service Commission, in an address in 1981 when
timely capital was a major new issue for the telephone
industry.
 “And those (regulators) with a broad sense of fairness might
also want to see whether the old technology was underdepreciated because of their past refusals to accelerate
depreciation: or whether they allowed sufficiently high rates
of return to reflect this particular risk they would, in effect,
assign to shareholders.[1]”
[1] Zielinski, Charles A. Regulation, Technological Change and Capital
Recovery, Iowa State University Regulatory Conference 1981 Vol. 20
Iowa State University, Ames Iowa P. 431
Copyright © 2011 Deloitte Development LLC. All rights reserved.
12
Lack of Data: New Technology
 The staff experts at the Wisconsin Public Service
Commission discussed this lack of data in their 1930 book
when they observed that:
 “Many companies do not have mortality data on property.
Where there is a lack of such information, the only way the
exhaustion of service capacity or accrued depreciation on
an age and life basis can be measured is by
judgment….The life of the plant in service, however, is
entirely a question of judgment.[1]”
[1] Staff of the Public Service Commission of Wisconsin, Depreciation: A
Review of Legal and Accounting Problems, 1933 Public Service
Commission of Wisconsin, Madison, WI Page 194
Copyright © 2011 Deloitte Development LLC. All rights reserved.
13
Role of Judgment
 NARUC Committee on Engineering, Depreciation and
Valuation and published by NARUC in 1968. No more
explicit or stronger statement on the subject of the
application of judgment can be found than the statement of
the Depreciation Subcommittee that:
 “Average service lives – This is the single most important
component of the depreciation rate…The determination of
this figure is an engineering function since judgment
evaluation of the impact of present and future operating
conditions and technological developments on the life of the
plant is required in addition to mathematical and statistical
analysis of past experience.[1]”
[1] Depreciation Subcommittee of NARUC, Public Utility Depreciation
Practices, NARUC, 1968, Washington, DC, P. 41
Copyright © 2011 Deloitte Development LLC. All rights reserved.
14
Summary
 Traditional depreciation practice has always been able to
handle the introduction of new technologies.
 Depreciation rates must be set based on the expected
economic life of the assets.
 Regulation has recognized that engineering judgment can
be relied upon as the basis for such estimations.
Copyright © 2011 Deloitte Development LLC. All rights reserved.
15
Thank You! Questions?
Branko Terzic
[email protected]
Direct +1 703 251 4350
About Deloitte
Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, its member firms, and their respective subsidiaries and affiliates. As a
Swiss Verein (association), neither Deloitte Touche Tohmatsu nor any of its member firms have any liability for each other's acts or omissions. Each of
the member firms is a separate and independent legal entity operating under the names “Deloitte,” “Deloitte & Touche,” “Deloitte Touche Tohmatsu,” or
other related names. Services are provided by the member firms or their subsidiaries or affiliates and not by the Deloitte Touche Tohmatsu Verein.
Deloitte LLP is the U.S. member firm of Deloitte Touche Tohmatsu. In the United States, services are provided by the subsidiaries of Deloitte LLP
(Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Financial Advisory Services LLP, Deloitte Tax LLP, and their subsidiaries), and not by Deloitte
LLP.
Copyright © 2011 Deloitte Development LLC. All rights reserved.
17