March 31, 1976

Formulas Have Little Effect On Utility Rates

The debate between Tweedledee and Tweedledum over utility rate-making formulas seems to be sputtering to a halt without reaching a conclusion.

No matter.  The outcome wouldn't have changed much.

Consumers are up tight over the high cost of utility services - principally electricity and gas.  The monthly bills have shot up much more rapidly then the general cost of living.

Their reaction has been to attack the method whereby utility rates are set by the Public Utilities Commission of Ohio.

To understand the debate, and the reason for its futility, we must delve a little into the technical procedures for regulating utility companies.

Though a monopoly, a utility company is guaranteed a fair return on its INVESTMENT in equipment and lines.  This guarantee rests on the Fifth Amendment to the U.S. Constitution which prohibits the taking of private property for public use without just compensation.  What constitutes "just compensation" is the crux of the rate-making process.

Not so many years ago the courts held that a 6 percent return on investment was just.  More recently the courts have allowed 7 and 8 percent in recognition of the higher returns allowed on competitive capital during these times of inflation.

If we didn't expect the utility companies ever to expand or improve their services we could drive return on investment down to 3 percent, or even 1 percent.  However, we do require these firms to give us more and better service as requested.

To buy and build wire, pipe, generators, and the thousands of other expensive materials necessary, the utility companies have to go into the open money market.  The expansion money has to be borrowed from blokes like you and me who won't let go the shekels until we can get a return on our investment at least equal to savings certificates of deposits.  Currently this return is about 7 ½  percent.

Even with this return, private investors are not overly enthusiastic.  The U.S. Treasury competes for loan money with our own tax money.  The government has first call because it cares not what it has to pay in interest, being some one else's cash.  Consequently, U.S. Treasury bills sometimes hit eight percent and are risk free.

Thus, the return on investment becomes the controlling factor in setting utility rates.

About all a regulatory commission can do is dispute how much money a utility company really has invested.  This debate is the sum total of rate making.

Most of any utility company's investment is in machinery and lines which is fixed in place and has a long life.  It is this long life of equipment that provides most of the grist for the rate mill.

Private companies are allowed by the Internal Revenue Service to enter the price of new equipment on their books at actual cost when purchased.  Then, as the equipment wears out, or depreciates, the company is allowed to deduct the proportionate depreciation as a business expense.  The tax savings are accumulated to buy new equipment as the original wears out.  This procedure is known as ORIGINAL COST DEPRECIATED (OCD).

Utilities, on the other hand, can not by law accumulate large amounts of idle capital - a cost burden ultimately borne by the consumer.  Most regulatory commissions, including the PUCO, allow the company to enter on its books what it would cost to replace, or reproduce, that equipment in the current year.  The procedure is known as REPRODUCTION COST NEW (RCN).

In times of inflation, when the new cost of a piece of machinery is certain to be several times more expensive, utility companies and fair-minded regulatory authorities settle on RCN.  In long-term depressions, when reproduction costs may be the same or lower, OCD is the preferred formula.

Under pressure of discontented utility customers, or of demagogic politicians -both of which are rampant today an attempt is made to reverse the formulas to the prevailing economy.

It is all good window dressing.  It gives the politicians and lobbyists an opportunity to justify themselves.

Should the formula get too far out of line, however, the utility companies will go to the courts for relief.  Historically they have done this many times.

Undoubtedly this will be the route should the present legislation to reverse the existing RCN formula to OCD succeed.

Author: Lindsey Williams