Book depreciation is recorded as an expense on a utility's income statement to recognize the consumption or use of plant in-service or investment that provides utility service to customers. Book depreciation expense is a component of the utility's revenue requirements and is included in the rates that are charged to customers. Typically, a regulatory commission approves the book depreciation rates that are used to calculate the authorized level of depreciation expense used for setting rates. (Commissions approve depreciation rates that are multiplied by investment to develop an annual level of depreciation expense.) Generally, the higher the assumed depreciation expense, the more revenue a utility is allowed to collect from customers.

Book depreciation expense provides for recovery of the utility's original cost of its plant in-service over its useful life. In addition, the depreciation expense also contains a provision for net salvage. Net salvage is the value that is received from the sale or reuse of retired property (generally scrap value) less the cost of retiring such a property (cost of removal). Normally, for fixed utility assets, the cost of removal is much larger than the scrap value.

In many instances, the net salvage expense that is included in the depreciation expense greatly exceeds the actual level of expense that the utility currently incurs. The net salvage expense that is collected from ratepayers through depreciation may exceed the actual expense that the utility has incurred on average by five times. For example, in a recent depreciation filing, a large Midwestern utility requested to include $55 million of net salvage in its depreciation expense. However, a review of the utility's historical data showed that over the last five years, the utility had only incurred an annual level of net salvage expense of $15 million. Simply put, the utility wanted to collect from customers $40 million per year more than it was currently spending.

The questions are: Why does this occur? Why is the utility allowed to collect a level of expense that greatly exceeds its needs? What happens to the money that is not expensed?

Commissions generally do not rely on the actual level of net salvage expense when developing the net salvage component of the depreciation rates. Rather, the approved depreciation rates, which are used to calculate the depreciation expense, rely on net salvage ratios. The net salvage ratio is developed by taking the net salvage cost that is incurred when an asset is retired, in that year's dollars, and dividing that by the original cost of the asset, in its original year's dollars. On the surface, one may expect that approach to produce a reasonable result. However, more critical review reveals that it does not produce a reasonable result initially, because the difference in purchasing power of the dollar, i.e., the time value of money, between when the asset is placed in service and when the asset is retired is essentially ignored. By ignoring the time value of money, the net salvage expense that is authorized contains a significant amount of inflation. (It should be noted that total net salvage expense developed from this method will provide the correct amount of total net salvage over the useful life, if the future mirrors the past. The problem, however, is that customers pay the same amount of net salvage expense each year over the life of the plant in-service and the time value of money is ignored in customer rates.)

The net salvage expense is recorded in the year it occurs and the investment is recorded in the year it was installed. For utility property, the timing difference between these two events can be as much as fifty years. As a result, the net salvage expense that is included in customers' rates will include a significant provision for inflation.

For accounting purposes, the utility reflects the money that is collected in excess of its annual net salvage requirement from ratepayers in a reserve to be used when the actual net salvage expense will exceed the amount collected through rates. However, that date never seems to arrive. As the utility plant in-service grows, so does the amount of net salvage that the utility is collecting from ratepayers.

This excess net salvage expense collected from ratepayers provides the utility with a source of cash flow which is recognized in rates as a reduction in investment. This lowers the return requirement when a utility files a rate case. Therefore, the utility often argues that customers essentially earn a return on that money. However, this may only occur when a utility files a rate case.

The amount of money that a utility may collect in excess of its need can be significant. The Midwestern utility previously mentioned had already collected approximately $600 million in excess of its annual net salvage requirement. That is, the utility had collected from past ratepayers $600 million in excess of its past net salvage needs.

What is the solution? One answer is that the commission could include a net salvage provision in rates that reflects the level of net salvage cost that the utility can expect to incur during the test year. Alternatively, the commission could approve a net salvage component of the depreciation rates that recognizes the time value of money or the purchasing power of the dollar.

Ratepayers should continue to press commissions for rates that reasonably reflect the cost of providing service by participating in regulatory proceedings that approve depreciation rates. Paying excessive net salvage rates is not consistent with cost causation principles. In recent years, a few commissions have recognized this problem and have approved more reasonable levels of net salvage expense for ratemaking. However, these commissions are clearly in the minority.