Depreciation Considerations Under Energy Transition Scenarios

My estimates are that future electric generation (kWh) in the USA needs to be increased by a factor of five (5X) to meet these goals. The new installed electric capacity (kW) however will need to be increased significantly in excess of 5X due to the intermittency of solar and wind power and the need to charge enormous batteries (not yet available) to have 24/7 energy available to meet expected demand.  Supporting the new renewable electric generation will require a new or upgraded electric transmission and distribution network.  The following are some of the implications of the transition for the future depreciation expenses of regulated electric and gas utilities. The changes will be in the professional estimates of future service lives, cost of removal and salvage for each asset account.

New technology estimates 

One scenario is related to the introduction of new technologies in generation, transmission, storage, distributed electric generation (DER) and electric vehicle (EV) related charging equipment owned by the regulated utility. New technologies, offering no retirement history will require economic service lives, and cost of removal and salvage estimates based on the best available engineering and professional depreciation expert judgement.

Retirements due to functional obsolescence – inadequate capacity 

Existing transmission and distribution facilities may have inadequate capacity to handle the higher electric loads caused by switching home heating and cooking to electricity and the addition of more home chargers for electric vehicles. Thus, assets will need to be retired earlier than originally planned due to the inability of existing assets to provide adequate service. The challenge here is to recognize these factors early enough to have regulators approve new depreciation rates to fully depreciate the assets over their new shorter remaining lives.

Retirements due to functional obsolescence – failure to meet new environmental standards 

Electric utilities still owning and operating coal and natural gas fueled power plants face continuing issues of changing EPA emission regulations and the inability to, in the future, meet the standards of the new regulations. There is federal research money now being allocated to studies and pilots on carbon capture and storage (CCS) technologies which may enable these power plants to operate under the new Clean Air regulations. Depreciation analysts will need to monitor this closely. In addition, the CCS equipment, when added to rate-base in regulated electric utilities, will need separate depreciation rates, once again with no retirement history to support economic service life estimates.

Uncertain regulatory future for natural gas utilities 

In the case of natural gas distribution utilities, the future of natural gas service may be determined by legislation rather than by the regulators. This uncertainty may lead managements to request higher depreciation rates providing for greater certainty of capital recovery. Professor James Bonbright’s Principles of Public Utility Rates should be reread on these issues as his recommendation appears to me to be one of it being better to error on the side of more rapid capital recovery than risk non-recovery resulting in stranded costs.

Getting Depreciation Wrong

The result of future depreciation decisions can be “wrong” if either 1) the assets are retired before being depreciated leading to “stranded” investment or 2) the assets are fully depreciated but remain in service for a significant amount of time at zero net plant investment.

The impacts of being “wrong” are different in the two cases. The treatment of “stranded assets” is subject to numerous options and requires significant regulatory analysis and decision-making. A likely outcome in a stranded cost case is a regulatory order amortizing the net plant remaining in future utility rates.

In the case of fully depreciated assets remaining in service the impact on consumers would be that rates were slightly higher for a period prior to the end remaining life date and then rates would be reduced significantly as the assets in question remain in service at no cost in the revenue requirement due t zero rate base value and no further depreciation.

Hypothetically if the entire rate base were fully depreciated there would be no annual depreciation expense (except for new assets) nor any return on rate base in the annual revenue requirement. In that case regulators could switch from Rate-of-Return regulation to the Operating Ratio Method of rate setting.

Strange as it might seem for a utility to be fully depreciated and still providing service there are examples in the water utility industry. In those cases, the fully depreciated rate base occurred because the regulator previously allowed the water utility to depreciate, but not earn on, “contributed plant”.