Methods for Valuing Assets

Concession bid: Most commonly, the value that the government assigned to the assets at privatization for purposes of regulatory valuation of the assets. For example, if at privatization the government said that, for purposes of assessing rate of return, the initial value of the assets would be $1,000,000, then the regulator would use $1,000,000 as the starting value. This value would change over time because of capital expenditures and depreciation. Alternatively, the amount the private company paid for the assets at privatization or paid for the right to the concession.

Fair value: Fair value (also called economic valuation) estimates the value of the assets as part of the business.

Original cost: Original cost (also called historic cost accounting or HCA) values assets based on what the company actually spent for the assets when they were acquired. Example: In 1990, Utility Company spent $500,000 to purchase the materials for its fixed lines and $50,000 to install them. The original cost value of these assets is $550,000 before depreciation. (Depreciation is explained later.) This $550,000 would be considered the value of this addition to rate base under the original cost method.

Original cost valuation has the advantages of:

• being objective because the values are tied to financial records of actual transactions
• creating a match between the money that investors have provided and the money they get back.
• Investors provide money either through original capitalization or by allowing the company to reinvest retained earnings. Investors get their money back through depreciation and profits.
• transparency and predictability and widely used

Original cost valuation has the disadvantages of:

• being difficult to implement where accounting records are poor
• understating the economic value of assets during times of high inflation
• overstating the economic value of assets during times of rapid technological change
• providing misleading economic signals to markets when used to establish relative prices

To balance these advantages and disadvantages, most regulators use the original cost method for assessing earnings and the replacement or current cost method for investigating costs for rate design

Replacement Cost

Replacement cost (also called current cost accounting or CCA) values assets based on what it would cost to replace them if they were acquired today.

For example, if Utility Company were placing this same plant today, the materials would cost $530,000 and the installation would cost $56,000. The replacement cost value is $586,000.

Replacement costs may be determined either by finding current prices for assets, or by applying an inflation factor to the original cost. The inflation index method is the most popular.

Replacement cost valuation has the advantages of:

• being able to overcome deficiencies of poor accounting records if the current-price method is used
• potential for transparency
• closely matching the economic value of assets during times of high inflation
• closely matching basis for market entry decisions

Replacement cost valuation has the disadvantages of:

• being subjective because current prices may be difficult to find when purchasing is being done through contracts
• requiring exact inventories of assets and methods of compensating for technological change if the current-price method is used
• giving more money back to investors than they have provided
• lacking predictability
• ignoring optimal configuration
• may overestimate actual economic value of the assets

Accumulated Depreciation

Rate base excludes accumulated depreciation. In other words, the B in the formula includes the value of the plant less the amount by which it has been.

There are several depreciation methods available.

The most popular method is straight line depreciation. This method takes the difference between the value of the plant and the salvage value, and spreads it uniformly across the useful life of the plant.

The basic formula is

Annual depreciation = (Value - Salvage)/Useful life

Straight line depreciation is often criticized for not reflecting the rate at which plant actually decreases in value. Generally, plant decreases in value rapidly the first few years it is in service, and then more slowly in later years. Because straight line depreciation assumes a constant rate of decrease, it understates actual depreciation in early years and overstates actual depreciation in later years.

Accelerated depreciation methods, such as declining balance and sum-of-the-years-digits, more closely match the actual rate of decline in plant values.

Slow depreciation rates create problems for companies whose markets that are transitioning to competition. If the regulatory depreciation rates are slower than economic depreciation, the company's book value of its plant may be greater than the economic value of its plant. Once markets become competitive, market pressure may keep the company from ever charging prices sufficient to allow it to recover the cost of its plant and earn a fair rate of return. This discourages investment.

Standards for allowable operating expenses

Operating Expenses Definition: Operating expenses include costs of items such as supplies, labor (not used for constructing plant), and items for resale that are consumed by the business in a short period of time -- for example, less than one year.

Standards for accepting expenses

(The following questions are critical)

1. Was there arms length bargaining?
2. Was there conflict of interest in the transaction?
   • If the regulated company is for example engaging in transactions with its unregulated holding company, there is an incentive for the regulated company to buy more than it needs and at higher prices than it would if it were engaging in transactions with unrelated companies.Is the expense is a legitimate expense for providing the utility services. (This is similar to the used and useful concept)
3. Is the utility company inefficient or imprudent in incurring the expenses
   
4. Are the expenses representative of normal operations
   
5. Are the expenses adjusted for known changes such as pending wage increases or imminent decreases in numbers of employees.
   
6. Are expenses that some commissions have disallowed (at least in part) including research and development, affiliate transactions that were considered not to be arms length, charitable donations, lobbying expenses, and institutional advertising (i.e., advertising to establish a corporate image rather than to inform customers).
   

Above and below line treatment

Expenses included in the revenue requirement are generally referred to as being "above the line."Expenses disallowed are generally referred to as being "below the line."