Thoughts on Intergenerational Equity in Utility Ratemaking

Intergenerational Equity is a foundational principle of utility regulation that theorizes that the period for cost recovery of an investment should correspond to the time it is actually in use.  According to this “matching principle,” customers who “use” an asset should pay for that asset at the time it is used.  When the temporal match between cost recovery and use is in question, maintaining intergenerational equity can become a utility ratemaking issue.

In fact, the large capital programs that are common in the utility industry almost always involve some degree of intergenerational inequity.  The intergenerational inequity scenario occurs because the optimum size for constructing an asset almost never matches the current need, and because the typical formula for utility cost recovery involves a declining rate base due to straight-line depreciation, while a project’s benefits[1] typically increase over time due to general price rises in the economy.  This usually results in projects having an “economic crossover” point in time, before which costs exceed benefits, and after which benefits exceed costs. This situation is often described as the project having its costs “front-end loaded,” and its benefits “back-end loaded.”  This dynamic is shown in the below chart which is a hypothetical analysis of “Project A” (e.g., a wind farm or transmission line) over a 25-year period.

 

Source: Concentric Energy Advisors, Inc.

 

If regulators determine that the degree of intergenerational inequity is too great, they may look for mechanisms that can alter the cost-recovery profile to better match the project’s benefits. These mechanisms include rate phase-in plans, levelization methodologies, shaped depreciation expenses, and the use of deferral accounts.  However, it can be important to recognize that while cost recovery for a single asset of a utility may be skewed as compared to its benefits, cost recovery for the entirety of the utility’s assets may still be within reasonable bounds.

In some instances, legislators and regulators have opted for greater flexibility in applying the matching principle and the “used and useful” standard in order to advance specific policy goals.  For example,

These examples illustrate government support in the undertaking of large energy infrastructure projects and seeking to “de-risk” that development by harmonizing the ratemaking treatment of these projects with the government’s desire to see them developed in a timely and cost-effective manner.  While implementing such measures to achieve public interest benefits is certainly reasonable, regulators and utilities will still need to carefully analyze such investments to ensure that they make economic sense and are in the public interest before they are undertaken.

 

By: Benjamin O. Davis

Senior Project Manager

 

[1]  Customer benefits may be difficult to measure, but they are typically thought of as the value derived from the project, either in terms of market value, or avoided costs, as well as benefits derived from improvements in environmental impacts, reliability, and flexibility.

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