Resources and Energy 7 (1985) 71-74. North-Holland

Comments on

FINANCIAL AND OPERATING IMPLICATIONS OF ECONOMIC DEPRECIATION

Potential Reponses by Financial Institutions and Markets

Sally HUNT Consolidated Edison Co., New York, NY 10003, USA

Let me first reiterate the ground rules for this discussion: I am speaking for myself, not for Con Edison, and I have just a few comments on the paper by Hyman and his associates.

(1) Trending proposals are often associated in the press and in people’s minds with the problem of rate shock caused by new plants, although I have always viewed trending as a broader proposal. Now it is true that given current standard rate-making practices, and given the inflation of the past decade, a large new plant, even a relatively inexpensive one, will cause rate shock, particularly if it is added to a relatively small rate base. The application of trending methods has been suggested to avoid the rate shock in these cases. .

The confusion arises because some of these new plants are now so much more expensive than their sponsors ever intended or estimated that they have been cancelled, and some are being continued because the costs of com- pletion are less than the total benefits of the plant, even though with hindsight the sponsor, had he known the eventual cost, would not have started it in the first place. I would like to call these plants ‘mistakes’, in a non-pejodative way.

The basic political problem in these cases is who should pay for mistakes - the customer or the stockholder or the go’vernment. But this issue is quite separate from trending, although it is obviously at least as important. I would only ask that they not be confused.

But we cannot escape the fact that the two issues are linked in the minds of important actors in the rate shock saga; in our discussions it is very important to distinguish those two questions, because some people with consumers’ interests at heart seem to see trending as a way to get the consumers out of paying for mistakes, and some of the opposition to

0165-0572/85/$3.30 0 1985, Elsevier Science Publishers B.V. (North-Holland)

72 S. Hunt, Comments

trending comes from the stockholders interests, who fear that trending will be a way to avoid solving the question of who will pay the prudently incurred costs of these plants.

For example, there are some proposals for the rate treatment of new plants (I am thinking of a current proposal in California) which would treat the utility as a cogenerator, and have the customers pay the utility only the avoided cost for the new nuclear unit. This proposal would in effect decide the issue of who should pay for mistakes, in favor of the consumer. But trending is not a way to finesse questions of prudence or policy. It is the way to distribute charges after questions of prudence and policy have been decided.

The historic practice has been to have customers pay all prudently incurred costs, e,ven if the investment turns out to be a mistake. If this practice is discontinued, it will be a fundamental change in regulation (and Edward Berlin has shown us that the precedent is being set for such a change). If commissions disallow prudently incurred costs of construction, then there is no doubt that the balance of risk will be changed and the cost of capital will rise. It is not trending that causes the cost of capital to rise; it is the possibility of the change of balance of risk through a change in the treatment of disallowances. But it would be naive to suppose that some people have not used trending as a cover for disallowances.

The single biggest obstacle to introducing any form of trending is the fear of regulatory mischief, and to any utility that was thinking of trending I would strongly suggest that they get it in writing that this is a deferral of cash for rate base, preferably passed by the legislature and signed by .the governor; if the entry of a plant into the rate base is delayed, the temptation never to put it in becomes very strong.

(2) There is a persistent assumption that trending would raise the cost of capital. But why should it? The British experience with indexed bonds suggests that they have sold fairly consistently at a 3% real interest rate. What real interest rate are utility bonds selling at today? Is it lower than 3%? The bonds I own are yielding 13 or 14% today. In the past the bondholders have been expropriated by the customers - the real return on most utility bonds was zero or negative for many years. Anyone committing their money to long-term bonds will demand a risk premium to prevent that happening again, unless there is some inflation protection. So why should inflation protection not bring the cost of debt capital down?

As for the cost of equity, the two things that are most dangerous to stockholders is that they lose their assets, or they lose their customers. Deferring cash may not sound so wonderful unless the alternative is losing assets to prudency hearings, or losing customers to elasticity. Deferring cash may actually reduce the cost of capital if these are your alternatives.

(3) I’d like to make a couple of technical comments to add to my Public

S. Hunt, Comments 73

Utilities Fortnightly papers: First, the most important rule is still to price all the output at marginal cost. Trending one plant may or may not improve the relation of price to marginal cost, depending on the previous level of rates. Trending over the life of a single asset is only appropriate for a single asset firm selling into a market with known and continuously rising prices for the product. It happens to be the easiest example to give.

Second, the examples I gave in those papers did not include the effects of rising operating and maintenance (O&M) costs, which are after all the reason a plant would be replaced in the end. The thing that should be trended are the total charges on the plant, and if O&M costs are rising, the capital component should be less trended.

Third, we might give some thought to normalization of accelerated cost recovery (ACRS), as required under the Economic Recovery Tax Act 1981, as a substantial cause of the rate shock. CWIP in rate base gives you cash when you need it, and mitigates the price shock effects. The current tax law gives you money after the horse has bolted and magnifies the price shock effects.

Fourth, in the formulas and computations I gave, the trending was done at the ‘rate of inflation’. But the speed of technical progress should offset the rate of inflation to some extent, and reduce the amount of the trending. Technical progress has not been very evident of late in this industry, but when I was ten we did not have a TV in the house. An five years ago I had never heard of a micro-computer. We have to be a little careful not to build up assets on the books just as they become obsolete in the ground.

(4) Which brings me to my last point - whatever happened to the declining cost industries? Supposedly, the reason for regulation is that inevitably the big guys have economies of scale. Now we see cogenerators coming along on a very small scale, doing it cheaper. They have no problems trending - in fact Leonard Hyman is from Merrill Lynch, a firm which has been actively promoting financial arrangements which enable cogenerators to take advantage of rising (trended?) prices from the utilities for the purchase (at avoided cost) of their output. How do they structure these deals - well, the stockholders take capital gains instead of cash, and the federal govern- ment chips in tax benefits. Sounds familiar? It sounds a lot like the various trending proposals to me! The private market seems to be able to cope with trended payments without fainting at the lack of front-end loading. (Although, to be fair, the utilities are in some cases helping out with prepayments of the capacity credits.) If the private market can do it, it should be possible for utilities, which have the advantage of multiple assets.

If competitors can trend their rate bases, and still make economic investments, the electric industry cannot afford not to consider carefully the economic time pattern of charges. It would be shooting itself in the foot to resist trending if that is the way to keep prices in line with marginal cost.

74 S. Hunt, Comments

Hanging on to the traditional means of ratemaking may keep the current prices way above what makes economic sense, and let competitors get their trended feet in the door.

And yet I find myself very aware of the other aspect of this same phenomenon - if competition is developing, we may want to be careful about building up book assets; we should be thinking of depreciating them faster, remembering how AT&T got caught with their depreciation reserves down when competition presented itself.

The trending literature suggests that the pattern of charges over time does not have to be immutably fixed by the existing methods of regulated ratemaking: a careful examination of the appropriate time patterns of charges in the face of potential competition is the real challenge of the current situation.

References

Streiter, Sally Hunt, 1982, Trending the rate base, Public Utilities Fortnightly 109, 10, 22-27. Streiter, Sally Hunt, 1982, Indexed bonds and other issues, Public Utilities Fortnightly 109, no.

12, 4CL47. Streiter, Sally Hunt, 1982, Avoiding the ‘money saving’ rate increase, Public Utilities Fortnightly

109, no. 13, 18-22.