Duke Power & Light just spent $10 million to repair one of its electrical grid substations that was heavily damaged by a lightning strike. The loss was not insured.Required:Why would a utility ask the public service commission for approval to treat the $10 million as an asset for rate-making purposes rather than as an allowed expense?

Question

What will be an ideal response?

Answer 1

After studying the effect of this request on the utility's revenues (using the typical rate formula presented in the text and reproduced below) it should become apparent that this request may not be in the utility's best interests. Whether it is or not depends in large part upon when, and how frequently, utility rates are revised. 

Allowed revenue = Operating costs + Depreciation + Taxes + (ROA × Asset base). 

If the repair is treated as an operating cost, Duke can recover the entire $10 million in the current year and again every year thereafter until the rates are revised. Thus, if rates are to be revised in the current year, but not again for a few years, Duke is better off to expense the repair. On the other hand, if the repair is expensed in the current year and rates are not revised until some year in the future, the $10 million will never be recovered from the utility's customers. If the repair is added to the asset base, some of the amount of the repair will be reflected in increased depreciation charges and the asset base will be increased thus increasing the allowable return on assets. Both of these effects will raise revenue, and for a number of years in the future. However, the amount of this revenue increase will not be as great as the increase that occurs if the costs are expensed-although the increase may be more enduring, and time value of money needs to be considered as well due to the extended cost recovery period.