Resources and Energy 7 (1985) 115-118. North-Holland

Comments on

INCENTIVE EFFECTS OF UTILITY RATE TRENDING

Rodney STEVENSON University of Wisconsin, Madison, WI 53711, USA

If the tenets of economics are valid, the structure of revenue requirement determination systems should have incentive effects with regard to a broad spectrum of public utility activities such as the choice of projects to be undertaken, the technology to be utilized in projects, and the timing of project completion. The existence and importance of these utility incentive effects have long been recognized by Schuler and others who work in the area of public utility economics. Unfortunately, though, this awareness is not universally shared. While in rate case after rate case claims are made that the investment community pays meticulous attention to the detail of each component of the revenue requirement formulation - the utility industry has in general held that its system operations are influenced only by customer demands and engineering imperatives.

Recent concern with rate shock resulting from the completion of very high cost large scale projects (e.g., nuclear plants) has prompted interest in rate trending. Rate trending in general, and the specific approach afforded through the adoption of economic depreciation, would result in a significant change in revenue requirement or rate level determination methods. In considering the appropriateness of such a major modification to traditional regulatory practices, it is only reasonable to inquire into the incentive implications of the proposed change.

Perl, in his article ‘Incentive Effects of Utility Rate Trending’ has made a first effort at such an inquiry. In identifying four methods of rate trending (extent of CWIP in rate base, phasing new plants into rate base over time, tying rates to a general cost index, and adopting economic depreciation), Per1 considers potential incentive effects on investors, utility managers, and consumers. He concludes that rate trending in any of its various forms will avoid rate shock and hence avoid underutilization of capacity through ‘uneconomic conservation and fuel substitution’. He further concludes that investors are likely to be unaffected unless they perceive rate trending as an enforced foregoing (instead of a deferral) of cost recovery. Per1 suggests that

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use of a regularized--system such as economic depreciation, rather than the other ‘ad hoc trending procedures’, will avoid undesirable utility investor incentives.

While endeavoring to evaluate the incentive effects of rate trending is extremely important, the task is extremely difficult. The difficulty arises not only from the need to predict the reaction of consumers, managers, and investors to specific revenue phasing conditions, but from the necessity to identify the specific manner in which rate trending will manifest. Though each of the rate phasing approaches has its own idiosyncrasies, I will address only the approach utilizing economic depreciation.

Economic depreciation, in Perl’s words, ‘would allow the book value of equipment to explicitly reflect . . . changes in market value’. The market value of the equipment would in turn be affected by inflation, changes in customers’ preferences, the existence of accessible substitute products, and technological obsolescence. Holding aside the obvious ‘fair value’ dilemma that, in the. regulatory setting, market value and price are circular or reciprocally determinative, and assuming that the dominating factor is inflation in the early years and physical deterioration in the later years, the time path of economic depreciation would yield depreciation levels low in the beginning and rising over time. Various economists and other utility industry observers [e.g. Bower (1983), Streiter (1982a, b, c) and Myers et al. (1981)-j have proposed the adoption of economic depreciation in the revenue determination process, especially under conditions where traditional revenue requirement methods would result in severe rate shock.

In assessing the efficiency impacts with respect to consumers, one should keep in mind that it is the end result, i.e., the price level, which is important and not the structure or characteristics of the individual components of the revenue requirement determination formula which underlie the price. Given that there are several components to the revenue requirement formula, one should consider the offsetting effects of the other factors and evaluate whether adoption of economic depreciation will move price in the direction toward or away from a level which is economically desirable. If one wishes prices to reflect marginal costs, it is not necessarily the case that adoption of economic depreciation will move price closer to marginal costs. In various regions of the country and for various utilities, price levels derived from traditional rate setting practices are greater than marginal costs. Adoption of economic depreciation when price exceeds marginal costs would move price into closer alignment with marginal costs - at least in the short run. Where price is below marginal costs, adoption of economic depreciation would result in a greater disparity.

Though economic depreciation may have intuitive appeal, at least to economists, the manner of adoption will have a direct bearing on the end result. In this regard, several important questions still remain unanswered.

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Will economic depreciation apply to all projects, all new projects, all new and large projects or only those where severe cost overruns threaten substantial rate shock? How will the original investment be recovered? Should economic depreciation lead to a potential under- or over-recovery, will a ‘true up’ be imposed (and if so, how)? How will inflation, changing consumer preferences, changing competitive circumstances and technological obsolescence be taken into account in charting the path and level of economic depreciation? What will the effect be on the calculation of utility taxes and the timing of tax benefits? Will the price result be adjusted to avoid ‘price squeeze’ if the state commission adopts economic depreciation for determining retail rates but the Federal Energy Regulatory Commission does not do the same in establishing wholesale rates? The range of alternative outcomes is substantial!

Economic depreciation methods are currently being advanced as a solution to the rate shock problem, a problem which is limited to those utilities unfortunate enough to be bringing on line very large generation projects which have experienced substantial cost overruns. As such, these methods are not a solution to all high cost project problems; economic depreciation does not provide a means of determining the appropriate degree of ‘used and usefulness’, nor does it provide a guide for assessing project imprudence. Rather, economic depreciation provides a handy tool for sculpting rate trends. Over the last decade several modifications to the basic revenue requirement determination method have been adopted to provide for a more ‘desirable’ (at least in the minds of the proposers and adopters) trend of rates. CWIP in rate base, tax normalization, future test periods, year end rate bases, attrition allowances, automatic adjustment clauses, etc., were all adopted to provide for improved cash flows. Though the problems addressed by these modifications were relatively short term, the efficiency consequences may be long term in nature. Unfortunately the increasing complexity of the revenue procedures augur against understanding the efficiency incentive consequences of these actions.

While it is possible that the adoption of economic depreciation could result in an improvement in allocation and production efficiency, other routes would probably yield a more direct result. If improvement in efficiency is the primary objective, the following would probably be more fruitful: mainten- ance of performance measurement systems, encouraging utilities to establish performance monitoring divisions such as done by Wisconsin Electric Power Company and by the Jacksonville Electric Authority, open electric power markets to more competition, and improve pre-project review and construc- tion monitoring.

The need for some form of rate trending, at least for selected utilities, seems clear. Whether the adoption of- economic depreciation is the best way to achieve a desirable time path of rates is less clear. Adoption of economic

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depreciation should take place only after careful study. However, economic depreciation should not be adopted if its prime purpose is to cover up construction mistakes. The studies generated by the National Science Found- ation will contribute substantially to better understanding where we should go from here.

References

Bower, Richard S., 1983, Testimony before New York State Public Service Comission, Case 28252, Investigation into Shoreham Nuclear Generating Station ratemaking principles (Albany, NY).

Streiter, Sally Hunt, 1982a, Trending the rate base, Public Utilities Fortnightly 109, no. 10, 22- 27.

Streiter, Sally Hunt, 1982b, Indexed bonds and other issues, Public Utilities Fortnightly 109, no. 12, 40-47.

Streiter, Sally Hunt, 1982c, Avoiding the ‘money saving’ rate increase, Public Utilities Fortnightly 109, no. 13, 18-22.

Myers, Stewart C., Lawrence A. Kolbe and William B. Tye, 1981, Inflation and rate of return regulation, review draft (MIT, Cambridge, MA).