Depreciation and Capital Recovery for the Utility Industry

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• Depreciation and Capital Recovery for the Utility
  Industry
• SURFA
• 38th Financial Forum
• April 27 and 28, 2006
• Donald J. Clayton, P.E., CFA, CDP

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DEPRECIATION

• From a Valuation Perspective
• Depreciation is defined as the loss in service
  value not restored by current maintenance or
  covered by insurance.
• From an Accounting Perspective
• Depreciation is the allocation of the cost of
  fixed assets less net salvage to accounting
  periods - a capital recovery concept.
• From a ratemaking perspective both the valuation
  (rate base) and accounting (capital recovery)
  concepts of deprecation are important.

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DEPRECIATION AND REVENUE REQUIREMENTS

• Revenue Requirements OM Depreciation Taxes
  Return
• Return ROR x Rate Base
• Rate Base Plant in Service Accumulated
  Depreciation Deferred Taxes Working Capital
  Contributions - Advances
• Depreciation is important as both an annual
  expense and as a reduction of rate base.
• Depreciation expense is one of the largest line
  items in the cost of service.

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DEPRECIATION SYSTEMS

• Defining a depreciation system for just a single
  unit requires a chain of decisions.
• What do you need to select?
• 1. A concept
• Physical Condition
• Decrease in Value
• Cost of Operation
• 2. Allocate over time or units of production
  (use)
• (Time is more prevalent)
• 3. A method
• (Straight line is normal for utility company
  bookkeeping)

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ACCELERATED AND DECELERATED METHODS

• Methods that have early depreciation accruals
  higher than straight line depreciation accruals
  are called accelerated methods. (e.g. SYD and
  DDB)
• Methods that have early depreciation accruals
  lower than straight line depreciation accruals
  are called decelerated methods.
• (e.g. Compound Interest)

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ACCELERATED AND DECELERATED METHODS, Cont.

• The SEC does not currently permit the use
  decelerated depreciation methods for financial
  reporting. Economists like decelerated methods
  to determine economic depreciation.
• Accelerated methods are prevalent for tax
  depreciation purposes.
• Utilities generally use straight line for both
  book and ratemaking purposes.

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COMPARISON OF DEPRECIATION SYSTEMS
Single unit, 1,000 COST, 5 year life, 0 Net
Salvage
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DEPRECIATION PARAMETERS

• Under any depreciation system you need to
  estimate service life and net salvage parameters.
• Service life can be the life of a single unit or
  a dispersion pattern (survivor curve) which
  represents the range of lives expected for all of
  the items in a group.
• Service life is normally expressed in years but
  can be expressed in units of production.
• Net Salvage can be either positive or negative
  for utility companies but is limited to positive
  net salvage for companies not subject to
  regulation.
• Today all companies are required to accrue for
  AROs known to exist.

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STRAIGHT LINE DEPRECIATION

• The straight line depreciation calculation for a
  single unit is relatively simple
• For example
• A single item
• Cost 1,000
• Life 5 years
• Net Salvage 0
• The annual depreciation expense Cost x (1-net
  salvage) / life 1000 x (1-0)/5 200

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SUM OF THE YEARS DIGITS DEPRECIATION
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DECLINING BALANCE DEPRECIATION
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COMPOUND INTERESTDEPRECIATION
Detail of Compound Interest Method (10 Interest)

• You can use any interest rate deemed
  appropriate.
• (But look up the annuity for that rate!)

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DEPRECIATION ALTERNATIVES
In some cases it is desirable to estimate service
life in Units of Production rather than the
passage of time in years.

• Units of production might be used for the
  following
• A gas well (MCF of gas)
• A coal mine (Tons of Coal)
• A forklift truck (hours of use)

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ANNUAL DEPRECIATION

• DEVELOPMENT OF FORMULAS FOR STRAIGHT LINE

Annual Accrual Service Value / Service Life

(Cost Net Salvage) x (1/ Service
Life) Accrual Rate (1- Net Salvage
Ratio) x (1/Service Life)
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ACCUMULATED DEPRECIATION
Calculated Accumulated Depreciation (CAD)
CAD Age x Annual accrual
Age x (Cost Net Salvage) x (1/ Life)
(Age/Life) x (Cost Net
Salvage) CAD Ratio (Age/Life) x (1 Net
Salvage Ratio)
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GROUP DEPRECIATION
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SERVICE LIFE AND DISPERSION
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DEPRECIATION CALCULATIONS
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DEPRECIATION CALCULATIONS, Cont.
Average Life (5 15) / 2 10 Average Net
Salvage 0
Accrual Rate 1/L (1 S)
1 / 10 0.10
or 10
Annual Accrual .10 x 2,000 200
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ACCUMULATED DEPRECIATION

Year Entry Debit Credit Balance 1
Accrual 200 200 2
Accrual 200 400 3
Accrual 200 600 4
Accrual 200 800 5
Accrual 200 1,000 5 Retirement
1,000 0 6 Accrual
100 100 7 Accrual 100
200 8 thru 14 Accruals 700 900 15
Accrual 100 1,000 15 Retirement
1,000 0
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ACCUMULATED DEPRECIATION, Cont.
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ACCUMULATED DEPRECIATION, Cont.
ALTERNATIVE APPROACH
Annual Accrual 1/LA(1-S)CostA
1/LB(1-S)CostB 1/5 (1-0) 1,000 1/15
(1-0) 1,000 0.200 X
1,000 0.067 X 1,000
267 Composite Annual Accrual Rate 267/ 2,000
13.33 What is the accrual after Unit A is
retired?
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ACCUMULATED DEPRECIATION, Cont.
ACCUMULATED PROVISION FOR DEPRECIATION
Year Entry Debit Credit Balance 1
Accrual 267 267 2
Accrual 266 533 3
Accrual 267 800 4
Accrual 267 1,067 5
Accrual 266 1,333 5
Retirement 1,000 333 6
Accrual 67 400 7
Accrual 67 467 8 thru 14
Accruals 466 933 15 Accrual
67 1,000 15 Retirement 1,000
0
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ACCUMULATED DEPRECIATION, Cont.
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DEPRECIATION SYSTEMS
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DEPRECIATION SYSTEMS, Cont.
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DEPRECIATION SYSTEMS Cont.
1. Concept (a) Physical (b) Valuation
(c) Cost of Operation 2. Depreciate over (a)
Time (b) Units of Production 3. Depreciate as
a (a) Unit (b) Group Property 4. Method of
Allocation (a) Straight Line (b) Accelerated
(c) Decelerated 5. Group Procedure (a)
Average Life (b) Equal Life Group 6. Method of
Adjustment (a) Amortization (b) Remaining
Life 7. Group Model (a) Broad Group (b)
Vintage Group
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NET SALVAGE
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NET SALVAGE, Cont.
Average Life Procedure
Annual Accrual 1 / Average Life (1-SA) (Cost)
The salvage factor (SA) in this case is the
average net salvage ratio for the entire life
cycle - the same period as the basis for the
average life.
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NET SALVAGE, Cont.
Average Life Procedure
CAD Cost Future Salvage Future
Accruals Cost Cost x SF Cost x Avg R /
Avg L (1-SA) Cost (1-SF) Avg R / Avg L
(1-SA)

• Where the salvage factor (SF) is the average
  net salvage
• for the future (remaining life) period - the
  same period as
• for the calculation of the average remaining
  life, and
• Salvage factor (SA) is the average net salvage
  ratio for
• the entire life cycle - the same as the basis
  for the
• average life.

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NET SALVAGE, Cont.
Are the average net salvage (SA) and the future
net salvage (SF) the same value? Only if SF
SA, can the formula be reduced to the following
CAD Cost (1 - SF) Avg R / Avg L (1 - SA)
Cost (1-Avg R / Avg L) (1 S)
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NET SALVAGE, Cont.

• Considering the 2-unit example, assume that
• Unit A has 25 salvage when retired at age 5,
  and
• Unit B has negative 5 salvage when retired at
  age 15

Average Salvage 0.25 x 1,000 (-0.05 x
1,000) / 2,000 250 50
200 Average Percent Salvage 200 / 2,000
0.10 or 10
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NET SALVAGE, Cont.
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NET SALVAGE, Cont.
Average Life Procedure
Accrual Rate 1 / Avg Life (1 SA) 1
/ 10 (1 - .10) 0.09 or 9.00 Annual Accrual
.09 x 2,000 180
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NET SALVAGE, Cont.
EQUAL LIFE GROUP PROCEDURE
Annual Accrual ? (1 / Life) (1-SG) (Cost)
1 / 5 (1 - .25)1,000 1 / 15
(1-(-0.05))1,000 .2 x .75 x 1000
.067 x 1.05 x 1000 150 70
220
The salvage factor (SG) in this case is the net
salvage ratio for each equal life group, or unit
- the same group, or unit, that has the life used
in the formula.
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DEPRECIATION SYSTEMS
CONTINUOUS GROUPS

• Our examples have been very simplistic
• A single vintage group
• Discrete curves
• Not very realistic
• Typical group property includes many vintages
  and countless numbers of individual units

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DEPRECIATION SYSTEMS
THE BROAD GROUP MODEL

• In the broad group model, depreciation
  calculations for all vintages are defined
  solely by the single estimated survivor curve
  and single estimated Salvage schedule.
• Is it reasonable to represent all vintages of a
  
• property group by a single survivor curve and
• salvage model?

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DEPRECIATION SYSTEMS
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DEPRECIATION SYSTEMS
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DEPRECIATION SYSTEMS
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DEPRECIATION SYSTEMS
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DEPRECIATION SYSTEMS
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DEPRECIATION SYSTEMS

• The life cycle of a property group consists of
  realized
• life and future life.
• Realized life is the historical portion of the
• cycle, both known and unknown (if any,
• which must be estimated).
• Future life is the future portion of the
  cycle,
• always unknown. Must be estimated.

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DEPRECIATION SYSTEMS








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DEPRECIATION SYSTEMS
THE LIFE SPAN OR FORECAST METHOD

• Applicable to group for which concurrent
  retirement of all vintages is expected
• Special case of vintage group model

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DEPRECIATION SYSTEMS

• Groups for which life span method is used -
• Large individual units such as power plants and
  major buildings
• Systems tied to a supply or market such as a
  pipeline
• Systems subject to rapid technological
  obsolescence over a short period such as metallic
  cable

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DEPRECIATION SYSTEMS

• Survivor characteristics are described by an
  interim survivor curve and the probable
  retirement date
• The life span of each vintage is different and
  results in a unique survivor curve for each
  vintage

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DEPRECIATION SYSTEMS
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DEPRECIATION SYSTEMS

• Composite whole lives and remaining lives can be
  based on the use of different group procedures,
  i.e., average life and equal life, for different
  vintages
• Often used when ELG adopted on a go-forward
  basis

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RATE CASE IMPLICATIONS

• Utility depreciation is a specialized field than
  involves considerable judgment.
• Service Live
• Net Salvage
• Methods and Procedures
• Easier to attack than many other cost of service
  items.
• Companies generally want the highest revenue
  requirement
• shortest service lives
• highest cost of removal
• lowest gross salvage
• ELG
• Generally intervenors want the opposite of what
  the Company wants

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DEPRECIATION CONTROVERSIES

• Net Salvage is the hottest issue today
  particularly o the west coast.
• Cost of Removal exceeds original cost in some
  cases.
• Lack of data to support estimates makes it easy
  argue for amortization of experience rather than
  predict the future
• ARO accounting under FAS 143
• Use of ELG
• Higher early accruals make it hard to gain
  acceptance of the method in some jurisdictions.
• Use of statistical analysis instead of informed
  judgment
• Le t the computer pick service lives and survivor
  curves

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DEPRECIATION CONTROVERSIES, Cont.

• Usually the largest group is attacked
• Mains for a gas or water company
• Poles and overhead conductor for an electric
  company
• Life spans for power plants
• Historical issues
• Theoretical vs. actual depreciation reserve
• Decommissioning of nuclear and fossil plants
• Whole Life vs. remaining life
• Straight line vs. compound interest method

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FUTURE ISSUES

• Proscribed Rates and/or Lives
• IRS
• RUS
• Surface Transportation Board
• Lack of historical record keeping
• Other rate regimes
• Incentive ratemaking
• Value of service vs. cost of service
• Lack of depreciation expertise