E421-12 - CHAPTER 12 CHAPTER ENGINEERING ECONOMY ENGINEERING STUDIES IN INVESTOR-OWNED UTILITIES UTILITIES INVESTOR-OWNED UTILITIES INVESTOR-OWNED

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Unformatted text preview: CHAPTER 12 CHAPTER ENGINEERING ECONOMY ENGINEERING STUDIES IN INVESTOR-OWNED UTILITIES UTILITIES INVESTOR-OWNED UTILITIES INVESTOR-OWNED Investor-owned utilities provide services: • Gas • Electric power • Water • Telephone communications • Environmental Protection • Some types of transportation Etc… Etc… UTILITIES HISTORY UTILITIES • Because they are usually monopolistic, Because management of utilities has been customarily a government responsibility. customarily • However, utilities have undergone a strong However, privatization movement in last quarter of 20th century. 20 • The Private Producers Act is the U.S. is The government’s aid to private investors becoming involved in public utilities UTILITIES HISTORY UTILITIES Because all levels of U.S. government have Because granted monopolistic power to utility companies, they maintain right to continue regulating utilities. Commission roles include: Commission PUBLIC UTILITIES COMMISSION • Protecting customers against Protecting discriminatory pricing and service discriminatory • Setting rates to avoid excessive profits • Establishing and maintaining standards of Establishing service service UTILITIES HISTORY UTILITIES PUBLIC UTILITIES REGULATORY PUBLIC POLICIES ACT (PURPA) POLICIES • 1979 legislation addressed the issue of 1979 efficient energy use. efficient • Required utilities to purchase power from Required available industrial sources and pay the same kilowatt / hour rate that they would charge had they generated it. UTILITIES HISTORY UTILITIES DE-REGULATION • Allows power companies located in one Allows state to sell its services (electricity) to and own plants in other states own • A primary issue becomes how to maintain primary high reliability of service among deregulated electric companies deregulated CHARACTERISTICS OF INVESTORCHARACTERISTICS OWNED UTILITIES 1. High capital investment per worker and high High fixed to variable-cost ratio fixed 2. Services demanded by customers must be Services rendered at the established rate schedules rendered 3. Utility must keep up with related technical Utility developments that can enhance service developments 4. Service rates based on total costs plus after-tax Service fair return on rate-base value of property 5. Service rates must provide sufficient profits to 5. Service pay adequate dividends to attract enough capital needed for service requirements 1. Lack of high profit incentive reduces desire to Lack continually improve operation continually 2. Although maximum limit (i.e., 12 – 16%) placed Although on earnings, there is no guarantee of profit or against loss. But commission may allow a rate increase if conditions are deemed appropriate increase 3. Because of stable nature, utilities commonly Because finance capital expenditures with higher percentage of borrowed capital than non-utilities percentage 4. Assets of utilities involve longer write-off periods Assets than non-utilities than 5. Capital is much more readily available to utilities Capital than non-utilities CHARACTERISTICS OF INVESTORCHARACTERISTICS OWNED UTILITIES UTILITY ECONOMY STUDIES CONCEPTS CONCEPTS 1. Reflect interests of customer, rather than Reflect interests of owners 2. Investor-owned utility studies examine 2. Investor-owned alternatives to service approach alternatives 3. Administrative and general supervision Administrative expenses frequently omitted because they don’t change between approaches don’t 4. Costs of money, depreciation, income Costs taxes, and property taxes usually expressed in terms of capital invested expressed REVENUE REQUIREMENT METHOD REVENUE • Calculates the revenues a given project Calculates must provide to meet all costs, including fair return to investors fair • Most widely used economic evaluation Most method for privately-owned regulated utilities utilities • Because consumers are central focus, Because investment project selection is made on basis of minimum revenue requirements REVENUE REQUIREMENT METHOD REVENUE Minimum Revenue Requirement: • Carrying charges resulting from capital investments that must be recovered must • Periodic expenses ( I.e., fuel, O&M expenses, property taxes, and insurance) and REVENUE REQUIREMENT METHOD REVENUE CARRYING CHARGES (also called total fixed charges) Interest on bonds used to partially finance Interest project project Equity return requirements for Equity stockholders stockholders Income taxes to be paid to state and local Income governments governments Depreciation charges on investment • • • • REVENUE REQUIREMENT METHOD REVENUE CARRYING CHARGE EQUATION CCk = DBk + [( 1- λ) ea + λ ib ] . Uik + Tk Ui λ) DBk = book depreciation taken in year k, 1< k < N book Bk λ = fraction of borrowed money in a utility’s total fraction capitalization capitalization ea = return to equity capital (as a decimal) return ib = cost of borrowed capital (as a decimal) cost Uik = unrecovered investment at the beginning of of year REVENUE REQUIREMENT METHOD REVENUE CARRYING CHARGE EQUATION CCk = DBk + [( 1- λ) ea + λ ib ] . Uik + Tk Ui λ) DBk = book depreciation taken in year k, 1< k < N book Bk λ = fraction of borrowed money in a utility’s total fraction capitalization capitalization ea = return to equity capital (as a decimal) return ib = cost of borrowed capital (as a decimal) cost Uik = unrecovered investment at the beginning of of year I (initial investment), k = 1 (initial Uik =< Uik-1 – DBk-1, 2 < k < N Ui REVENUE REQUIREMENT METHOD REVENUE CARRYING CHARGE EQUATION CCk = DBk + [( 1- λ) ea + λ ib ] . Uik + Tk Ui λ) DBk = book depreciation taken in year k, 1< k < N book Bk λ = fraction of borrowed money in a utility’s total fraction capitalization capitalization ea = return to equity capital (as a decimal) return ib = cost of borrowed capital (as a decimal) cost Uik = unrecovered investment at the beginning of of year I (initial investment), k = 1 (initial Uik =< Uik-1 – DBk-1, 2 < k < N Ui REVENUE REQUIREMENT METHOD REVENUE INCOME TAX IN ANY GIVEN YEAR Tk = t ( CCk – λ . ib . Uik – DTk) DTk = Tax depreciation in year k Tax Tk t = effective income tax rate effective Tk = [ t / ( 1- t)] [ (1 – λ )ea . Uik + DBk – DTk ] )] Revenue Requirement in year k RRk = CCk + Ck Ck = All recurring annual expenses in year k COMMON ASSUMPTIONS OF REVENUE REQUIREMENT METHOD REVENUE 1. Total investment in asset during any given year equals Total its beginning-of-year book value its 2. Amount of debt capital invested in asset during any Amount year is a constant fraction of that year’s book value; fraction remains constant for asset’s life fraction 3. Equity and debt capital involve constant rates of Equity return throughout project life return 4. Book depreciation charges used to retire capital stock Book and bonds each year in proportion to debt-equity mix of financing of 5. Effective income tax rate is constant over project life UTILITY-RATE REGULATION UTILITY-RATE • Changes in utility’s cost or income precipitate Changes a regulatory rate proceeding to consider justification for new rates justification • Proceeding first determines acceptable return Proceeding on investor’s equity based on: on – what is required to instill investor confidence – what other utilities are permitted in same business what risk environment risk – what is fair and reasonable • Revenues are then calculated to yield required Revenues return on equity return TWO CRITERIA FOR UTILITY RATE REGULATION REGULATION Return on Equity Calculates the ratio of net income available Calculates for common stock (i.e, given in utility’s income statement) to average or end-of year common equity (i.e.,given in utility’s balance sheet) balance The revenue requirement is then increased The or decreased to meet return-on-equity target or TWO CRITERIA FOR UTILITY RATE REGULATION REGULATION Return on Rate Base More traditional rate regulation criterion Rate base = total plant in service total Rate - accumulated depreciation reserve + materials and supplies (optional) + fossil fuel inventory (optional) + working capital allowance (optional) - deferred income taxes (optional) - deferred investment tax credit (optional) + construction work in progress (optional) COST OF CAPITAL AND CAPITALIZATION STRUCTURE CAPITALIZATION After-Tax Cost of Debt i’a = i’b - t i’b = ( 1 - t) [( 1 +ib )( 1 + f ) - 1 ] i’b = inflation-adjusted cost of borrowed capital inflation-adjusted = [( 1 +ib )( 1 + f ) - 1 ] [( t = effective income-tax rate f = average annual inflation rate COST OF CAPITAL AND CAPITALIZATION STRUCTURE CAPITALIZATION After-Tax Cost of Capital (K’a) K’a = λ i’a + ( 1 - λ ) e’a e’ λ = fraction of borrowed money in the utility’s total capitalization total capitalization capitalization ( 1 - λ ) = fraction of equity capital in total e’a = inflation-adjusted equity rate = [( 1 + ea )( 1 + f ) - 1 ] REAL AFTER-TAX COST OF CAPITAL (Ka) (K Ka = [ (1 + K’ ) / ( 1 + f ) ] - 1 (1 a = λ ( 1 - t ) ib + ( 1 - λ )ea - λ tf 1+f ea is the real equity rate is FLOW-THROUGH ACCOUNTING FLOW-THROUGH • • • Used in revenue requirement method of Used project comparison project Requires income tax savings be passed Requires on to utility customers These savings (credits) may be from: a) b) c) Accelerated depreciation Investment credits (when available) Interest paid on funds used during Interest construction construction NORMALIZED ACCOUNTING NORMALIZED • Requires the afore-mentioned income tax savings Requires be amortized (depreciated) over the life of the project project • Used by most investor-owned utilities as a way of Used protecting the company against unforeseen changes in future income tax rates and state / federal laws that govern their operation • Almost exclusively used for setting rates on Almost services provided to customers services • Produces revenue requirements that are Produces frequently higher than those resulting from flowfrequently through method ...
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This note was uploaded on 10/28/2009 for the course ENGM 400 taught by Professor Blank during the Spring '09 term at American University of Beirut.

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