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


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Depreciation and Capital Recovery for the Utility Industry SURFA 38 th Financial Forum April 27 and 28, 2006 Donald J. Clayton, P.E., CFA, CDP. DEPRECIATION. From a Valuation Perspective:

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

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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 = O&M + 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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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)

DEPRECIATION ALTERNATIVES

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


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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

YearEntryDebitCreditBalance

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

YearEntryDebitCreditBalance

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


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