Jason Mumm, global director of financial, commercial and risk services
For many, the financial world is a mysterious place where good people and great ideas go to meet their untimely demise, or worse, an audit. For many utilities, financial constraints loom large and there is no larger a financial issue than the replacement of aging assets, a problem the American Water Works Association says will cost Americans a trillion dollars. Where will the money come from? If you’re dedicated to Building a Better World, this is certainly one of the questions that must be answered. One of the ideas that’s been made popular for better and for worse is to “fund depreciation.” What in the world does that mean, really?
What is depreciation after all? There is no financial term more misunderstood than depreciation. That’s because depreciation expense appears on a utility’s P/L statement as though it were just that, an expense, when in truth we are told that it is a “non-cash” expense. We don’t have to write a check each year to pay for depreciation yet it shows up as a reduction to our income nonetheless. What gives? Why has accounting done this to us?
Depreciation isn’t some accounting trick created to make us all look silly. Instead, it is essential to our understanding of the costs of producing the utility services provided. It bridges an important gap between investment and operating cost by very simply allocating a portion of the investment in physical assets to the annual operating costs. In plain language: it measures the portion of assets used each year to produce the utility services.
E.g. a utility invests $1M to acquire pipelines that will provide service for an estimated 50 years. During those 50 years, the utility will use $20,000 of that investment each year to produce its services.
Why is depreciation not funded already? At least in the U.S., where public ownership of utilities is the dominant structure, those responsible for raising the capital for investing in assets and those responsible for incurring and, therefore, paying for annual operating costs are one in the same. Thus, utility rate payers in the U.S. are often considered “owners” inasmuch as they provide equity capital (from their rates), and elect a governing board to manage the utility’s affairs. Were the owners selling the services to some other party, they would no doubt be keenly interested in recovering their initial investment by ensuring operating revenues exceeded operating costs, including depreciation expenses. However, as owner-customers, ratepayers are much less interested in recovering their own money since doing so would be to pay twice for the same investment: once upon the initial investment and again through the depreciation charges. Instead, most public agencies charge nothing for depreciation expenses but rather recover from their rates the hard costs related to principal and interest on borrowed capital, plus additional amounts to raise new capital for identified needs. For the most part, the latter amount is and has been insufficient for the industry as a whole, which is why there is a trillion-dollar “hole” in U.S. water and sewer assets.
Is “funding depreciation” a viable solution? In a word, no. On the plus side, the idea of funding depreciation would increase the level of equity contributed to the utility enterprise from the owners (i.e. the rate payers). However, the message and the method are both disingenuous. From a messaging standpoint, the owners have already paid for the investments in question in one form or another; asking them (the owners) to pay a second time for the same investments lacks logical consistency, and that will always make for a difficult message for ratepayers to swallow. As far as the methodology goes: it is full of fatal flaws and does a lot less to solve the issue at hand than proponents would admit.
- Fatal flaw number one: A portion of the utility’s assets are already fully depreciated and, therefore, have no related depreciation expense anymore. Meanwhile, these assets are still in service and will need to be replaced at some cost. Collecting zero depreciation expense will obviously fail to address those future costs.
- Fatal flaw number two: Some assets are closer to their eventual replacement date than others. If you start funding depreciation right now for assets that are already partly depreciated, you will recover just part of the initial investment for those assets. Collecting less than the future replacement cost can only partially solve the problem at best.
- Fatal flaw number three: Depreciation is based on historical cost, not present or future values. Imagine buying a car for $32,000 knowing you will replace it in eight years. You save $4,000 per year and at the end of eight years you have $32,000 to replace the car. Good job! Unfortunately for you, the cost for a car equivalent to the one you bought eight years ago is now $45,000 leaving you $13,000 short of replacing the vehicle. Even full funding of depreciation is likely to leave you short.
Avoiding the real issue. Depreciation was never meant to be a proxy for the cost of future replacement of capital assets. Saying that it is does not make it so, and the rally cry to “fund depreciation” is only the most recent of a string of band aid approaches avoiding the real issue, which is failure to engage in true asset management practices. Better to gain a strong understanding of the expected future costs and, maybe more importantly, their timing. Asset management does that, and true financial planning brings it home for quality decision making about the future.
