Branko Terzic, P.E., Sc.D. (h.c) Executive Director, Deloitte Center for Energy Solutions Regulatory...

Branko Terzic, P.E., Sc.D. (h.c)Executive Director, Deloitte Center for Energy SolutionsRegulatory Policy Leader, Energy & Resources, Deloitte Services LP

University of Texas Interdisciplinary Energy Conference

April 7-8, 2011

Smart Grid: Capital Recovery

2Copyright © 2011 Deloitte Development LLC. All rights reserved.

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


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


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.


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.


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.


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


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.


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


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.


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


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 under-depreciated 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


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


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


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.

Branko Terzic

[email protected]

Direct +1 703 251 4350

Thank You! Questions?

mailto:[email protected]

17Copyright © 2011 Deloitte Development LLC. All rights reserved.Copyright © 2011 Deloitte Development LLC. All rights reserved.

About DeloitteDeloitte 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.

Branko Terzic, P.E., Sc.D. (h.c) Executive Director, Deloitte Center for Energy Solutions Regulatory...

Documents

Transcript of Branko Terzic, P.E., Sc.D. (h.c) Executive Director, Deloitte Center for Energy Solutions Regulatory...