Case No. U-15629; In the matter of the Application of Consumers Energy Company for Accounting Approval of Depreciation Rates for Gas Utility Plant

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1 A CMS Energy Company April, 00 Ms. Mary Jo Kunkle Executive Secretary Michigan Public Service Commission Mercantile Way P.O. Box 0 Lansing, MI 0 General Offices: One Energy Plaza Tel: () -00 Jackson, MI 0 Fax: () - or () - *Washington Office: 0 Rhode Island Ave. N.W. Tel: (0) -0 Suite 00 Washington, DC 00 Fax: (0) - Writer s Direct Dial Number: () - Writer s Address: mblittle@cmsenergy.com LEGAL DEPARTMENT JAMES E BRUNNER Senior Vice President and General Counsel JON R ROBINSON Vice President and Deputy General Counsel Utility Law and Regulation Shelley J Ruckman Kimberly C Wilson Michael G Wilson Assistant General Counsel David E Barth H Richard Chambers John P Dickey Deborah Ann Kile M Bryan Little Kathrine M Lorenz Eric V Luoma Raymond E McQuillan Rhonda M Morris Deborah A Moss* Mirče Michael Nestor Robert M Neustifter Vincent P Provenzano Susan L Rasmussen John C Shea Scott J Sinkwitts P Leni Staley Charlotte A Walls Attorney Re: Case No. U-; In the matter of the Application of Consumers Energy Company for Accounting Approval of Depreciation Rates for Gas Utility Plant Dear Ms. Kunkle: Included in this electronic file is the Rebuttal Testimony of Dane A. Watson. This is a paperless filing and is therefore being filed only in a PDF format. I have also enclosed a proof of service. Sincerely, M. Bryan Little CC: Parties per Attachment to Proof of Service fl00-0

2 S T A T E O F M I C H I G A N BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION In the Matter of the Application of ) CONSUMERS ENERGY COMPANY ) Case No. U- For Accounting Approval of ) Depreciation Rates for Gas Utility Plant ) REBUTTAL TESTIMONY OF DANE A. WATSON, PE CDP PARTNER, ALLIANCE CONSULTING GROUP ON BEHALF OF CONSUMERS ENERGY COMPANY April, 00

3 0 0 I. POSITION AND QUALIFICATIONS Q. PLEASE STATE YOUR NAME AND ADDRESS. A. My name is Dane A. Watson, and my business address is 0 Avenue K, Suite 0B, Plano, Texas 0. I am a Partner of Alliance Consulting Group. Alliance Consulting Group provides consulting and expert services to the utility industry. Q. ARE YOU THE SAME DANE A WATSON WHO FILED DIRECT TESTIMONY IN THIS CASE? A. Yes. Q. WHAT IS THE PURPOSE OF YOUR REBUTTAL TESTIMONY IN THIS PROCEEDING? A. I provide rebuttal testimony on behalf of Consumers Energy regarding depreciation policy issues raised by Mr. William W. Dunkel on behalf of Attorney General of the State of Michigan ( AG ) and Mr. James T. Selecky on behalf of the Association of Businesses Advocating Tariff Equity ( ABATE ) in their testimony filed in this case. Specifically, I address Mr. Dunkel s and Selecky s assertions that the amount of removal cost included in the Company s depreciation rates is excessive. I also address and demonstrate why the positions of Mr. Dunkel and Mr. Selecky with regard to discarding the traditional method of accruing net salvage are not appropriate and should be denied. Q. ARE YOU SPONSORING ANY REBUTTAL EXHIBITS? A. Yes. I am sponsoring: Exhibit A- (DAW-), which is entitled Asset Depreciation Expense "Purchasing Power" Recovery $00 Initial Investment; Exhibit A- (DAW-), which is entitled Calculation of Total Cost of Tradition Method Versus "Purchasing Power" Method Current, Future and Nominal Cost; and Exhibit A- (DAW-), which is entitled Consumers Energy s Correction of ABATE's Proposed Depreciation Rate Exhibit AB-.

4 II. OVERVIEW 0 0 Q. PLEASE DESCRIBE IN GENERAL THE PROBLEMS WITH MR. DUNKEL S AND MR. SELECKY S RECOMMENDATIONS. A. Between depreciation experts reviewing the same data, there can be valid differences in interpretation of results in a depreciation analysis. To what extent to reflect trends in the data, which curve best matches history and the weight of future expectations of a company s engineering experts are examples of information that play a role in determining the most appropriate lives and net salvage to project for a company. However, Mr. Dunkel s and Mr. Selecky s recommendations do not encompass valid disagreements between depreciation experts using theoretically correct depreciation concepts. In both cases, radically different approaches are suggested whose ultimate result is to dramatically reduce the Company s current depreciation expense at the expense of future customers. Mr. Dunkel accepts the concept of accruing for future removal cost (as does the Company) but disregards the accepted straight-line recovery of removal cost replacing it with a sinking fund type of approach which creates a back-end loading of depreciation expense for future customers. Mr. Selecky, on the other hand, disregards the theoretically sound depreciation concept of accruing removal cost for future retirements. Instead, he suggests only accruing for the removal cost levels that he believes will be seen in the next few years. He ignores the fact that the bulk of the Company s assets will retire later than the time frame he proposes. His recommendation will have future customers paying for the removal for most of the Company s assets even though current customers are using and receiving the benefit of those assets. Neither approach is supported by valid depreciation theory and creates an unfair benefit to current customers at the expense of future customers.

5 III. REBUTTAL TO THE ATTORNEY GENERAL S WITNESS MR. WILLIAM DUNKEL 0 0 Q. PLEASE SUMMARIZE THE REMOVAL COST ARGUMENT PRESENTED BY MR. DUNKEL IN HIS TESTIMONY. A. To summarize Mr. Dunkel s testimony, he asserts that the purchasing power of money is different in different years. Therefore, the Company s removal cost recovery should be reset to collect the same purchasing power adjusted costs from customers each year. Based on this assertion, Mr. Dunkel recommends radically reducing the Company s removal cost recovery in order to charge each year s customers the same amount of purchasing power and keeps the Company from allegedly over collecting removal cost over the life of the assets. Q. DO YOU AGREE WITH MR. DUNKEL S ASSERTION THAT REMOVAL COST SHOULD BE RECOVERED BASED ON PURCHASING POWER? A. No. Mr. Dunkel s argument is flawed and will result in significantly higher costs to customers with dramatic intergenerational inequity to customers over the life of the assets. Q. HOW ARE MR. DUNKEL S ARGUMENTS FLAWED? A. There are a number of areas where Mr. Dunkel s arguments and logic are flawed. First, Mr. Dunkel s use of the term purchasing power is a red herring. I know of no Commission that uses purchasing power as a test for analyzing the appropriateness of depreciation expense. For Mr. Dunkel s argument to be taken seriously, he would also have to admit that the recovery of the cost of the Company s fixed assets over a straight-line basis would significantly under-collect the purchasing power that the Company is receiving for its investment in fixed assets (i.e. the depreciation expense on the assets themselves). He would then have to dramatically increase the depreciation expense required to recover the full purchase power of its asset investments. Appropriately, I am aware of Webster s New College Dictionary defines red herring as something that distracts from the matter or issue at hand.

6 0 0 no Commission in the country has linked purchase power to asset depreciation expense. Second, although Mr. Dunkel claims that there is no major disadvantage to his approach, the reality is that his proposal will cost customers over the lives of the assets significantly more (both in a current dollar and future dollar basis) as compared to the Company s recommendation. Mr. Dunkel s recommendation is designed for the sole purpose of reducing depreciation expense for the benefit of current customers. Third, Mr. Dunkel s recommendation would create significant intergenerational inequity between generations of customers and create an economic time bomb that will go off in the face of future customers. Fourth, in spite of Mr. Dunkel naming his method a FERC Order method, FERC does not recommend nor use a FAS approach in setting depreciation rates. Fifth, Mr. Dunkel s suggestion contradicts all authoritative depreciation guidance. Mr. Dunkel s suggestion that the straight-line method of recovering net salvage is not appropriate for negative net salvage is simply untenable. Authoritative texts and training on depreciation since the 0 s through today have continued to recommend the straight-line depreciation method for life and net salvage (even though net salvage continues to be more and more negative). Sixth, adopting Mr. Dunkel s concept would require the Company to file for new depreciation rates each year in order to recover the amounts suggested under Mr. Dunkel s methodology. Q. PLEASE ELABORATE ON THE UNDER-COLLECTION OF PURCHASE POWER THAT THE STRAIGHT-LINE DEPRECIATION OF FIXED ASSETS WILL INCUR UNDER MR. DUNKEL S CONCEPT. A. Mr. Dunkel used an example of an asset that costs $00 and will last 0 years. Using straight-line depreciation, $0 of the asset s cost would be recovered each Direct Testimony of Mr. Dunkel, Page line. Direct Testimony of Mr. Dunkel, page footnote.

7 0 0 0 year for 0 years. This $0 is considered the nominal value (i.e. the value in the year the cost was incurred). Under Mr. Dunkel s paradigm of looking at purchase power, the Company would only recover $ of purchasing power for the asset cost since the $0 in recovery would have increasingly less purchase power every year after the asset is put in service. The $ is the total real value or current value (i.e. the value of the future costs deflated back to the current year). Therefore, the Company is only collecting % of the purchasing power of the asset cost over the life of the asset. In order to collect the same purchasing power for the asset cost, the Company would have to significantly increase its depreciation expense for just its asset cost. As shown above, when Mr. Dunkel s paradigm is applied to the recovery of the asset cost itself, the unreasonableness of his concept becomes clear. Mr. Dunkel proposes just that concept for one of the four components (removal cost) of the asset s overall cost (the four components being the installation cost, the material cost, the removal cost and the scrap value) while ignoring the loss of purchase power on other components. I am unaware of any Commission that would allow such a skewed recovery of an asset s depreciation expense so why should any commission allow the skewed recovery of the asset s removal cost. Q. PLEASE EXPLAIN WHY MR. DUNKEL S REMOVAL COST RECOMMENDATION WILL COST THE CUSTOMERS SIGNIFICANTLY MORE THAN STRAIGHT-LINE RECOVERY OF REMOVAL COST. A. Mr. Dunkel fails to disclose a very significant cost that will occur under his proposal additional carrying costs of the unrecovered removal cost. Under regulated accounting, every dollar of removal cost recovered from customers is charged to the depreciation reserve. Each dollar added to the depreciation reserve reduces the Company s rate base. Each dollar deferred (the effect of Mr. Dunkel s proposal) increases the Company s rate base as compared to the straight-line method. The additional rate base cost of Mr. Dunkel s proposal would dramatically increase the total cost customers must pay for every asset over its life. I will demonstrate using the 0 year life of Plastic Mains that See Exhibit A- (DAW-) for the annual equivalent purchase power depreciation expense for the asset.

8 Mr. Dunkel discusses on page of his testimony. Exhibit A- (DAW-) reflects this calculation. The results are shown below. Method Nominal Value Future Value Current Value Straight-line method $ 00 $, $ "Purchasing Power" Method $,0 $, $ The nominal value (Exhibit A- (DAW-) column (c)) shows the straight-line recovery of $00 in removal cost over 0 years. Mr. Dunkel s proposed purchasing power recovery of removal cost also equals $00 but is back-end loaded as seen in (Exhibit A- (DAW-) Column (d)). The cumulative effects on rate base of using Mr. Dunkel s paradigm are shown in (Exhibit A- (DAW-) Column (f)). Mr. Dunkel s purchasing power recovery of removal cost over the same 0 years with the effects on rate base included in the calculation are shown in (Exhibit A- (DAW-) Column (l)). The true cost of Mr. Dunkel s proposed purchasing power method is $,0, which is % higher than the straight-line amount of $00. This significantly higher cost demonstrates the effects of Mr. Dunkel s removal cost deferral on rate base. The future value of the cost of the straight-line method and Mr. Dunkel s proposed purchasing power method (shown in Exhibit A- (DAW-) Column (g) and (h) respectively) and the current values of the straight-line traditional and Mr. Dunkel s purchasing power method (shown in Exhibit A- (DAW-) columns (i) and (j), respectively) show that both values are significantly higher than under the straight-line method. Both the future value cost and current value cost of Mr. Dunkel s proposal would be over 0% higher than under the straight-line method. In light of these significantly higher life-cycle costs, it is no surprise that nearly every Commission in the country has used and continues to use the traditional straight-line recovery of removal cost. Q. WHY WOULD MR. DUNKEL S CONCEPT CREATE INTERGENERATIONAL INEQUITIES? A. As discussed above, Mr. Dunkel inappropriately dismisses the rate base effects (and future maintenance costs) in his argument that purchasing power adjusting Nominal value refers to the cost in the year it is incurred.

9 0 0 0 removal cost expense is good for current and future customers. The reality is that, under his proposal, future customers will pay more for removal cost in depreciation expense than current customers. As shown above, future customers will also have a higher rate base (lower depreciation expense means higher net book value), which will require that they pay more for carrying the cost of the net book value of the assets. Future customers will also pay more in maintenance expense for the assets as the assets age. Finally, future customers will pay more for subsequent new assets used to serve them that are capitalized at a higher cost. Adding all these higher costs together shows that future customers are not benefited by Mr. Dunkel s alternative method, but instead hurt by his position, which will result in those future customers bearing an unfairly large shift in costs. Q. PLEASE PROVIDE AN ANALOGY FOR THE INTERGENERATIONAL INEQUITY PROBLEM CAUSED BY MR. DUNKEL S PROPOSAL TO REJECT HISTORIC PRECEDENT AND THE WELL ESTABLISHED DEPRECIATION METHODOLOGY IN FAVOR OF A PURCHASING POWER REMOVAL COST APPROACH. A. A good analogy for Mr. Dunkel s removal cost proposals as compared to Commission precedent (and the Company s proposal) is a balloon mortgage as opposed to a fixed rate mortgage for a homeowner. Under the existing removal cost paradigm of the Commission and the Company, the recovery of removal costs could be viewed as a fixed rate mortgage. In a fixed rate mortgage, the total future cost of the mortgage is paid evenly over the life of the loan. The current paradigm is that the estimated amount of removal cost required to remove assets at the end of their lives (parallel to the total mortgage cost) is accrued evenly or on a straight-line basis over the expected life of the assets (parallel to the loan period). The effect of adopting Mr. Dunkel s different paradigm on ratepayers is in effect to move from a fixed rate mortgage to a balloon mortgage. Under a balloon mortgage, a small payment sufficient to cover interest is paid each year until the balloon payment for the actual loaned amount is required. Paying this balloon payment will be a significant problem

10 0 0 unless the holder of the mortgage has been saving during the life of the loan for the eventual balloon payment. Mr. Dunkel s plan would have the Company accrue each year a small amount that would only cover a small portion of the necessary removal cost. Unfortunately, as with the balloon mortgage, this does not allow the Company to save for the dramatically higher cost to remove larger quantities of assets at future costs. Customers paying these balloon payment removal costs will be customers who are using the asset at the end of or after its useful life. The effect that this proposal has on the Company is clear. It will prevent the Company from accruing a reasonable level of removal cost on a consistent basis over the useful life of the plant asset. The effect of Mr. Dunkel s proposal on future ratepayers is also clear. Our grandchildren will be forced to pay a disproportional share of the removal costs of assets that we are using. Q. DOES THE COMPANY S STRAIGHT-LINE METHOD CREATE INTERGENERATIONAL INEQUITIES? A. No. In the same way as depreciation expense for assets is shared ratably by current and future customers, the straight-line approach used by the Company spread net salvage costs or benefits to all customers evenly. Q. IS MR. DUNKEL S CHARACTERIZATION OF HIS METHOD AS A FERC ORDER METHOD ACCURATE? A. No. FERC has not recommended or adopted Mr. Dunkel s FAS approach. As Project Manager for the Electric and Gas utility industry s adoption of FAS led by the American Gas Association/Edison Electric Institute, my opinion is that Order merely provides a mechanism for utilities to satisfy their Securities and Exchange ( SEC ) requirements related to FAS without requiring a second set of books in order to report under FERC Form or.

11 0 0 0 Q. PLEASE EXPLAIN FERC S STANCE ON FAS. A. The FERC has made no change in the treatment of non-legal ARO accruals or in the way it treats removal cost under rate regulation. In FERC Order, Section D: Accounting for Cost of Removal That Does Not Constitute a Legal Obligation, Paragraph, the FERC states, Under the existing requirements of the Uniform Systems of Accounts removal costs that are not asset retirement obligations are included as a component of the depreciation expense and recorded in accumulated depreciation. The Commission notes that certain jurisdictional entities may have been receiving specific allowances for cost of removal for non-legal retirement obligations as a specific component in their rates approved by their regulators. The Commission did not propose any changes to its existing accounting requirements for cost of removal for non-legal retirement obligations. Accordingly, jurisdictional entities are accounting for such costs consistent with the requirements of the Uniform Systems of Accounts under Part 0 for public utilities and licensees, Part 0 for natural gas companies and Part for oil pipeline companies. The FERC did not see a need to change the traditional process. As a matter of fact, FERC received comments suggesting the FAS concept be applied to regulated utility assets. This was firmly rejected by FERC (FERC Order Paragraph ): However, this issue is beyond the scope of this rule and we are not convinced that there is a need to fundamentally change accounting concepts at this time. The FERC was attempting to develop a financial presentation that would be acceptable to the SEC, the FERC, and the financial markets and not to change the course of history or long-established rate making practices. The FERC was presented with the issues surrounding the non-aro cost of removal and yet did not see the need to address the concerns raised by the commenter. FERC also states that adopting FAS for rate regulation would fundamentally change accounting concepts. Simply put, the FERC found that the rules in place were sufficient and a fundamental change in accounting concepts was not warranted. 0 FERC 0 (00) Id.

12 0 0 0 Q. PLEASE EXPLAIN HOW MR. DUNKEL S METHOD CONTRADICTS AUTHORITATIVE GUIDANCE. A. Mr. Dunkel s approach of establishing net salvage rates based on the present net value cost to remove assets that will not be retired for many years ignores authoritative utility depreciation publications. Q. WHAT ARE SOME PUBLICATIONS YOU CONSIDER TO BE AUTHORITATIVE? A. While there are other reputable publications on the topic of depreciation, the following are generally considered to be the preeminent authoritative publications on the topic: Frank Wolf and Chester Fitch s Depreciation Systems; and The National Association of Regulatory Utility Commissioners ( NARUC ) Public Utility Depreciation Practices ( Edition). Q. HOW DO THESE AUTHORITATIVE PUBLICATIONS CONTRADICT MR. DUNKEL S PROPOSED METHOD? A. Both the Authoritative Publications identified above agree that projecting the cost to remove assets at the end of their lives is a necessary factor in establishing net salvage rates. More specifically, NARUC s Public Utility Depreciation Practices supports the use of estimated future salvage and removal cost as part of the depreciation calculation. Specifically, NARUC s Public Utility Depreciation Practices states: Under presently accepted concepts, the amount of depreciation to be accrued over the life of an asset is its original cost less net salvage. Net salvage is the difference between the gross salvage that will be realized when the asset is disposed of and the cost of retiring it. Positive net salvage occurs when gross salvage exceeds cost of retirement, and negative net salvage occurs when cost of retirement exceeds gross salvage. Net salvage is expressed as a percentage of plant retired by dividing the dollars of net salvage by the dollars of original cost of plant retired. The goal of accounting for net salvage is to allocate the net cost of an asset to accounting periods, making due allowance for the net salvage, positive or negative, that will be obtained when the asset is retired. This concept carries with it the premise that property ownership includes the responsibility for the property s ultimate abandonment or removal. Hence, if current users 0

13 0 0 0 benefit from its use, they should pay their pro rata share of the costs involved in the abandonment or removal of the property and also receive their pro rata share of the benefits of the proceeds realized. This treatment of net salvage is in harmony with generally accepted accounting principles and tends to remove from the income statement any fluctuations caused by erratic, although necessary, abandonment and removal operations. It also has the advantage that current consumers pay or receive a fair share of cost associated with the property devoted to their service, even though the costs may be estimated. (Emphasis added.) Also, two of the most widely regarded experts on depreciation, Frank Wolf and Chester Fitch, state in their treatise Depreciation Systems: Effect of Inflation on the Salvage Ratio: One inherent characteristic of the salvage ratios is that the numerator and denominator are measured in different units; the numerator is measured in dollars at the time of retirement while the denominator is measured in dollars at the time of installation. (Emphasis added.) Drs. Wolf and Fitch further explain the importance of recognizing the future cost to retire current assets as follows: Negative salvage is a common occurrence. With inflation, the cost of retiring long-lived property, such as a water main, may exceed the original installed cost. Decommissioning cost of nuclear power plants is an example of large negative salvage. The matching principle specifies that all costs incurred to produce a service should be matched against the revenue produced. Estimated future costs of retiring of an asset currently in service must be accrued and allocated as part of the current expenses. The accounting treatment of these future costs is clear. They are part of the current cost of using the asset and must be matched against revenue. While the current consumers would say they should not pay for future costs, it would be unfair to the future users if these costs were postponed. Some say that although the current consumers should pay for the future cost, that the future value of the payments, calculated at some reasonable interest rate, should equal the retirement cost. Studies show that the salvage is often more negative than forecasters had predicted. 0. NARUC Public Utility Depreciation Practices, Page See Depreciation Systems, page. 0 See Depreciation Systems, pages and.

14 0 0 The Company has adhered to these teachings and well established methodologies by including future estimated removal costs in its proposed depreciation rates Mr. Dunkel has not. Q. DO YOU AGREE WITH MR. DUNKEL S CHARACTERIZATION OF A QUOTE FROM AN INTRODUCTION TO NET SALVAGE OF PUBLIC UTILITY PLANT? A. No. As general editor of An Introduction to Net Salvage of Public Utility Plant book quoted by Mr. Dunkel on page 0, lines - of his Testimony, I have firsthand knowledge that Mr. Dunkel used that quote out of context. The book (most recently published in 00) confirms the appropriateness of the use of the straight-line depreciation method used by the Company. Q. IS THERE ANY CONFUSION AMONG REGULATORY AUTHORITIES REGARDING THE CORRECT TREATMENT OF REMOVAL COSTS? A. No. Nearly every Commission in the country adopts the same approach as this Commission has always adopted, which is to include future estimated removal costs in net salvage rates. It is this precedent and sound policy on which I have relied to develop the proposed net salvage rates for the Company s assets in this case. Q. HAVE OTHER STATES EXPERIMENTED WITH A PATTERN OF REMOVAL COST RECOVERY OTHER THAN STRAIGHT-LINE RECOVERY? A. Although there are a couple states that have tried a different recovery method, most Commissions reject this approach. With respect to Pennsylvania, it is worth noting that Pennsylvania s practice is required under a court order interpreting a Pennsylvania law. Maryland adopted a different approach apparently in hopes of mitigating the rate impact of coming off a multi-year rate freeze. Another state, Missouri, experimented with alternative net salvage theories but quickly realized the error of this approach and no longer allows its use. Ameren UE, Final Order, ER00-000, and Staff response to Commission Order.

15 0 0 0 Q. PLEASE GIVE EXAMPLES OF OTHER STATE REGULATORY COMMISSIONS THAT HAVE REJECTED ALTERNATIVE REMOVAL COST PROPOSALS AND ADOPTED THE COMMISSION S PRACTICE OF INCLUDING ESTIMATED REMOVAL COST IN THE NET SALVAGE CALCULATION. A. A number of other states have rejected alternative removal cost proposals such as those suggested by Mr. Dunkel and Mr. Selecky. In Indiana, the Commission found that they: believe that there is a sound basis for the traditional approach on this issue [net salvage] that is utilized by a majority of states. Utilizing historical averages as an item to be expensed to current customers means that these customers will be paying for salvage costs at levels that may not be sufficient. That means that the next generation of customers will be paying for salvage costs related to facilities from which they may never have received service. The use of best estimates of future salvage costs addresses this inequity. In Missouri, the Public Service Commission of the State of Missouri found that: the fundamental goal of depreciation accounting is to allocate the full cost of an asset, including its net salvage cost, over its economic or service life so that utility customers will be charged for the cost of the asset in proportion to the benefit they receive from its consumption. In addition, as discussed below, the California Commission has examined Mr. Dunkel s basic approach and similar proposals three separate times and rejected the proposals each time. Q. WHAT ARE THE RECENT RULINGS IN CALIFORNIA ON THE NET PRESENT VALUE METHODOLOGY MR. DUNKEL ADVOCATES? A. California is a good example of how proponents of alternative methods have tried to enact this radical change in accounting for each of the large utilities in the state. In each case, the California Commission becomes more vehement in its rejection of this method. After rejecting the net present value proposals (as Indiana Utility Regulatory Commission Cause No. PSI Energy Order approved May,00, Page -. PSC of Missouri Case No. ER , Union Electric Order, May, 00 Pages. Pacific Gas and Electric, Decision 0-00,Dockets A.0--00, I March, 00.

16 0 0 0 Mr. Dunkel is recommending in this case) for Southern California Edison and Pacific Gas and Electric, the California PUC recently ruled in the San Diego Gas and Electric case, We reject, however, the analysis that DRA performed of actual removals compared to the accrual of salvage costs we find that the accrual of salvage costs in the past five years is not intended to fund the current removal in that same five-year period. The accrual in any one year is the fractional accrual for the eventual retirement of all outstanding plant as their service lives expire. We therefore find no meaningful conclusions from this analysis. D.0-0-0, July, 00 pp. -. The Commission further stated: [I]ntervening parties were not persuasive here, and have also failed to persuade the Commission in other recent proceedings, that current depreciation practices [to include future estimated removal cost in the net salvage calculation] are unreasonable or incorrect. In particular, TURN and UCAN argue applicants incorrectly calculate and recover negative net salvage values. We reject these arguments. Id. at. And in conclusion, the Commission stated: The alternative methodology proposed by TURN [which is the same method proposed by Mr. Dunkel in this case] was not adopted in the most recent Pacific Gas and Electric Company (PG&E) and Southern California Edison Company (SCE) GRCs. We would therefore have denied with prejudice the recommendations of DRA, TURN, and UCAN on depreciation and net salvage in a litigated decision. Id. at. Q. PLEASE DISCUSS WHY CONSUMERS ENERGY WOULD BE REQUIRED TO UPDATE DEPRECIATION RATES EACH YEARS. A. Under the straight-line method of depreciation recovery, depreciation rates would only change when a new estimate of life or net salvage percentage is warranted. Under Mr. Dunkel s proposal, the rates should automatically change each year. The annual increase in the amount that the Company must collect in order to fully recover its removal cost is an integral part of Mr. Dunkel s proposal. His purchasing power recovery of removal cost increases each year based on his arbitrary inflation estimate. If the Company did not file for new depreciation rates each year, not only would it not even recover the reduced removal cost inherent

17 0 in Mr. Dunkel s proposal but it would also add additional deferral of removal costs that future customers would have to bear (further increasing intergenerational inequities). Q. PLEASE COMMENT ON MR. DUNKEL S CRITICISMS OF THE COMPANY S FAS ANALYSIS. A. The FAS calculation submitted by the Company uses the same methodology as it uses in its compliance with FAS requirements for the Securities and Exchange Commission ( SEC ). The Company s program and methodology has been repeatedly validated by the Company s external auditors and accepted by the SEC. In addition, the program used by the Company to calculate the FAS results in this filing is used industry-wide by utilities to calculate FAS liabilities and accretion for filing with the SEC. In sum, Mr. Dunkel s criticisms are unfounded and are negated by the acceptance of the Company s methodology by auditors and the SEC. IV. REBUTTAL TO ABATE S WITNESS MR. JAMES SELECKY 0 Q. PLEASE DESCRIBE MR. SELECKY S RECOMMENDATION RELATED TO NET SALVAGE. A. Mr. Selecky argues that the Company is requesting seven times the amount of removal cost that it has experienced over the last years. He postulates that there is an excessive level of inflation included in the Company s calculation that caused this high level of removal cost. Consequently, he suggests dramatically lowering the net salvage rate for the Company by using the average removal cost for the last years inflated for 0 years at a rate of.% as the Company s net salvage rate. Q. DO YOU AGREE WITH MR. SELECKY S NET SALVAGE RECOMMENDATION? A. No. There are a number of reasons that Mr. Selecky s arbitrary suggestion should be rejected.

18 0 0 0 First, Mr. Selecky s overall depreciation expense calculation is fundamentally and theoretically flawed leading to an erroneous (and dramatically lower) recommendation than is warranted by his concept. Second, Mr. Selecky s calculation of the net salvage the Company is requesting is flawed in the same way providing false information to the Commission on which to base its decision. Third, Mr. Selecky fails to recognize that past removal cost expense levels are not representative of future removal cost expense levels. Fourth, his assumptions related to the inflation included in the Company s net salvage analysis are non-factual. Fifth, his recommended method is contradictory to authoritative depreciation theory and texts. Q. HOW IS MR. SELECKY S CALCULATION OF HIS OVERALL DEPRECIATION EXPENSE RECOMMENDATION FLAWED? A. As described on Page lines - of Mr. Selecky s Direct Testimony and demonstrated in Exhibit AB-, Mr. Selecky performed a depreciation rate calculation with a 0% net salvage rate for all accounts (trying to create asset-only depreciation rates or life rates). He then added the resulting expense from that calculation to the inflated -year average removal cost expense to determine the total depreciation expense that he recommends. His life rate calculation is not correct and contains a major flaw in the most basic of depreciation concepts the need to allocate depreciation reserve between the life and removal cost component in calculating depreciation rates. Mr. Selecky s calculation assumes that there has been no removal cost ever collected in depreciation rates at any point in the past. His calculation uses 00% of the depreciation reserve to calculate the annual accrual amount zero net salvage (i.e. depreciation expense related to the actual fixed assets). In other words, all accumulated depreciation reserves are used to reduce the depreciation rates attributable to the fixed assets. No depreciation reserve is allocated as removal cost already recovered in historical depreciation rates. With that assumption (which

19 0 0 Mr. Selecky otherwise recognizes is false ), his calculation will reflect all depreciation reserve as an offset to the fixed asset costs reducing the unaccrued balance, which is divided by the remaining lives, to calculate the asset depreciation expense. This creates a depreciation rate for the zero net salvage depreciation rate that is erroneous and dramatically lower than the correct levels. This flaw artificially lowers the depreciation expense he is recommending for the asset component of the depreciation rate which he then adds to the removal cost expense in his recommendation. Mr. Selecky s calculation will reflect 00% of all removal cost as needing to be collected over the remaining lives of the accounts when in fact nearly 0% has already been recovered. If the Commission were to rule that Mr. Selecky s proposed method should be used, this misapplication of depreciation theory must be corrected in order to have accurate information in the record. The corrected depreciation expense under Mr. Selecky s method is $,0, a reduction of $,0,0, not $,,0. The corrected calculation is shown in my Exhibit A- (DAW-). Q. HOW IS MR. SELECKY S CALCULATION OF THE NET SALVAGE REQUESTED BY THE COMPANY FLAWED? A. Mr. Selecky uses the same erroneous results of his calculation of depreciation expense related to the assets and subtracts that expense from the total expense requested by the Company to find his opinion of the removal cost the Company is requesting in rates. Since his asset depreciation expense is incorrectly calculated and dramatically lower than the actual amount, his reflection of the net salvage requested by the Company is consequently dramatically higher than the Company s actual request. The Company s requested removal cost is $,0, million per year, approximately $, million less than the $. million per year that Mr. Selecky suggests. The appropriateness of accruing more than was historically spent for removal cost is addressed below. Direct Testimony of Mr. Selecky, page lines -0.

20 0 Q. WHY IS IT NOT APPROPRIATE TO BASE THE FUTURE ACCRUAL OF REMOVAL COST ON THE HISTORICAL -YEAR AVERAGE REMOVAL COST (OR ANY HISTORICAL AVERAGE REMOVAL COST EXPENSE) INCURRED BY THE COMPANY? A. Past removal cost incurred for asset groups where the age of the asset group is significantly shorter than the average life if the group is not representative of future removal cost expense levels. The retirement pattern of the Company s assets is modeled by Iowa Curves. These retirement patterns demonstrate that the majority of assets retire around the average life of the asset group. Below is a graph of the retirement pattern of the Company s largest asset group - Account. Plastic Distribution Mains. The average life of this account is 0 years with an R Iowa Curve describing the pattern of retirements for the account. The graph shows the percent of the assets in the account that retire each year over the life of the group. Iowa Curve 0 R % Retired. 0. Average Age of investment Age % Ret

21 0 0 0 The average age of the Company s Plastic Distribution Mains is. years (shown by the arrow). As the account matures, it will experience significantly higher levels of removal cost expense as compared to history. Simply using history expense will not allow the Company to accrue for the much higher removal cost that it will experience in the future. This concept of accruing for future removal cost is the premise for accrual accounting. Under accrual accounting, the Company will ratably collect removal cost from all customers in order to have sufficient removal cost accrued when the assets are finally retired. By using data that only reflects a very small level of retirements, the Company s removal cost accrual will be set at an artificially low level that will not allow it to accrue a reserve to remove the assets at the end of their lives. All customers should contribute to the removal of the assets they are using, not just those near the end of the life of the assets. Q. IS PLASTIC DISTRIBUTION MAINS THE ONLY ACCOUNT THAT IS EXPERIENCING RETIREMENTS MUCH EARLIER THAT ITS AVERAGE LIFE? A. No. The Company s assets overall are experiencing this same situation. Mr. Selecky states that the average life of the Company s assets is approximately years. The average age of the Company s assets is only. years. This demonstrates that the recent removal cost experienced by the Company is early in the life of the assets. Basing the removal cost accrual for the Company on recent history when it will clearly increase significantly in the future is not appropriate. Q. IS THIS GROWTH IN RETIREMENTS REFLECTED IN THE NET SALVAGE ANALYSIS PROPOSED BY THE COMPANY AND ALSO DISCUSSED AND RECOMMENDED IN MODERN DEPRECIATION THEORY? A. Yes. The Company s recommendation follows the traditional method of calculating future net salvage. All authoritative sources agree that the traditional method is the generally accepted approach. This method takes into account the differing levels of retirements over time. NARUC s Public Utility Depreciation Direct Testimony of Mr. Selecky, Page line.

22 0 0 0 Practices supports the use of estimated future salvage and removal cost as part of the depreciation calculation. The publication, Public Utility Depreciation Practices ( addition) published by the National Association of Regulatory Utility Commissioners ( NARUC ) states: Under presently accepted concepts, the amount of depreciation to be accrued over the life of an asset is its original cost less net salvage. Net salvage is the difference between the gross salvage that will be realized when the asset is disposed of and the cost of retiring it. Positive net salvage occurs when gross salvage exceeds cost of retirement, and negative net salvage occurs when cost of retirement exceeds gross salvage. Net salvage is expressed as a percentage of plant retired by dividing the dollars of net salvage by the dollars of original cost of plant retired. The goal of accounting for net salvage is to allocate the net cost of an asset to accounting periods, making due allowance for the net salvage, positive or negative, that will be obtained when the asset is retired. This concept carries with it the premise that property ownership includes the responsibility for the property s ultimate abandonment or removal. Hence, if current users benefit from its use, they should pay their pro rata share of the costs involved in the abandonment or removal of the property and also receive their pro rata share of the benefits of the proceeds realized. This method examines how much it costs to remove each asset and projects that percentage cost to all assets on the books of a company. If the assets group is mature, the traditional approach will reflect a lower level of projected removal cost that is currently being experienced (as the Company is experiencing with its mature accounts). If it is a young asset group, it will appropriately reflect a higher amount that will allow both the recovery of the current removal cost expense and an accrual for future higher removal cost (as is the case with the Company s younger accounts). The Company s recommendation follows this concept; Mr. Selecky s method does not. Q. HOW IS MR. SELECKY S ASSUMPTIONS RELATED TO INFLATION IN THE COMPANY S NET SALVAGE ANALYSIS NON-FACTUAL? A. Mr. Selecky opines that the Company s average life of its assets is years; therefore he believes there are years of inflation included in the Company s analysis. This is factually incorrect. As described above by NARUC, the Company s analysis determines the cost (percentage of original cost) that each 0

23 0 0 0 recent retirement has experienced to remove that asset. Due to the young age of the asset groups, the average age of retirements that were examined by the Company is. years. This means that the Company has only experienced. years of inflation not the years that Mr. Selecky suggests. In addition, the assets that are still in service are an average of. years old. These inservice assets have already experienced historical inflation for. years. These. years of inflation are a fact and can not be ignored or pushed aside by alternative net salvage calculations. There is only years of nonexperienced inflation in the Company s analysis. Clearly, years of inflation will not have a significant effect on the future net salvage projected by the Company. Mr. Selecky s recommendation is based on a premise of many years of what is really non-existent inflation and should be ignored. Q. IS THE COMPANY S NET SALVAGE ANALYSIS CONCEPT SUPPORTED BY AUTHORITATIVE TEXTS? A. As shown above, NARUC definitively supports the traditional approach to net salvage analysis. Also, two of the most widely regarded experts on depreciation, Frank Wolf and Chester Fitch, state in their treatise Depreciation Systems: Effect of Inflation on the Salvage Ratio: One inherent characteristic of the salvage ratios is that the numerator and denominator are measured in different units; the numerator is measured in dollars at the time of retirement while the denominator is measured in dollars at the time of installation. Inflation is an economic fact of life and although both numerator and denominator are measured in dollars, the timing of the cash flows reflects different price levels. Drs. Wolf and Fitch further explain the important relationship between net salvage and inflation as follows: Negative salvage is a common occurrence. With inflation, the cost of retiring long lived property, such as a water main, may exceed the original installed cost. Decommissioning cost of nuclear power plants is an example of large negative salvage. The matching principle specifies NARUC s quote that some use a current cost approach is misleading. In, when the Manual was published, only one state used an alternative approach. That state is Pennsylvania. As discussed previously, Pennsylvania was required to use that approach due to a law not because of Commission decision. See Depreciation Systems, page :

24 0 0 that all costs incurred to produce a service should be matched against the revenue produced. Estimated future costs of retiring of an asset currently in service must be accrued and allocated as part of the current expenses. The accounting treatment of these future costs is clear. They are part of the current cost of using the asset and must be matched against revenue. While the current consumers would say they should not pay for future costs, it would be unfair to the future users if these costs were postponed. Some say that although the current consumers should pay for the future cost, that the future value of the payments, calculated at some reasonable interest rate, should equal the retirement cost. Studies show that the salvage is often more negative than forecasters had predicted. V. CONCLUSION Q. WHAT IS THE APPROPRIATE METHODOLOGY FOR ACCRUAL OF NET SALVAGE COSTS OVER THE LIFE OF THE COMPANY S ASSETS? A. As I have shown, estimating the future cost to remove the assets currently on the Company s books and ratably recovering that cost from all customers is the fairest approach for all customers. The methods proposed by Mr. Dunkel and Mr. Selecky back-end load significant levels of both asset and carrying costs pushing those costs away from current customers to future customers. This creates an inappropriate savings for current customers at the expense of future customers. The traditional method, used by most Commissions and historically by this Commission, treats all customers fairly. As with the recovery of the cost of the assets themselves, net salvage should be recovered on a straight-line basis from all customers who benefit from the use of the assets. Q. Does this conclude your rebuttal testimony? A. Yes, it does. See Depreciation Systems, pages and :

25 S T A T E O F M I C H I G A N BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION In the Matter of the Application of ) CONSUMERS ENERGY COMPANY ) Case No. U- For Accounting Approval of ) Depreciation Rates for Gas Utility Plant ) EXHIBITS OF DANE A. WATSON, PE CDP PARTNER, ALLIANCE CONSULTING GROUP ON BEHALF OF CONSUMERS ENERGY COMPANY April, 00

26 Asset Depreciation Expense "Purchasing Power" Recovery $00 Initial investment Exhibit A- (DAW-) Case No. U- April 00 Page of Current Value Year Straight-line Depreciation "Purchasing Power" (.%) (a) (b) (c) 0 $0.00 $.0 $0.00 $.0 $0.00 $. $0.00 $. $0.00 $. $0.00 $. $0.00 $. $0.00 $. $0.00 $.0 0 $0.00 $. $0.00 $. $0.00 $. $0.00 $. $0.00 $. $0.00 $. $0.00 $.0 $0.00 $. $0.00 $. $0.00 $. 0 $0.00 $. $0.00 $. $0.00 $. $0.00 $.0 $0.00 $. $0.00 $. $0.00 $. $0.00 $. $0.00 $. $0.00 $. 0 $0.00 $. $0.00 $.0 $0.00 $. $0.00 $. $0.00 $. $0.00 $. $0.00 $. $0.00 $.0 $0.00 $. $0.00 $. 0 $0.00 $. $0.00 $. $0.00 $. $0.00 $.0 $0.00 $.0 $0.00 $.00 $0.00 $0. $0.00 $0.0 $0.00 $0. $0.00 $0. 0 $0.00 $0. Total Recovery $00.00 $. Percent Recovery %

27 Calculation of Total Cost of Traditional Method Versus "Purchasing Power" Method Current, Future and Nominal Value Exhibit A- (DAW-) Case No. U- April 00 Page of Traditional Removal Cost Purchasing Power (PP) Removal Cost PP Carrying Cost Change (CC) Cumulative PP CC Change Future Value (FV) Traditional RC Current Value (CV) Traditional RC Nominal Value (NV) Traditional RC FV PP RC CV PP RC NV PP RC Year Age + CC + CC + CC (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (0.0) (0.0) (0.) (0.) (0.) (0.) (0.) (0.) (0.) (0.) (0.0) (0.) (0.) (0.) (.0) (.0) (.) (.) (.) (.0) (.) (.) (.) (0.00) Total ,., ,0. Increase ("Purchasing Power' versus Traditional) % % % Inflation Rate.% Cost of Capital 0.00% Life 0

28 Exhibit A- (DAW-) Case No. U- April 00 Page of CONSUMERS ENERGY Correction of ABATE's Proposed Depreciation Rate Exhibit AB- Book Annual Annual Book Depreciation Unaccrued Remaining Accrual Yr Net Salvage Annual Accrual Plant In Service Book Depreciation Depreciation Cost of Balance Life Amount Net Salvage In Accrual Accrual Rate Account //00 //00 Life Removal Life Only Life Only History Life + Salvage Life + Salvage () () () () () = ()-() () () = () / () () () = (() x.0)^0 (0) = () + () () = (0 )/ () G0.-Rights of Way,,,, 0,.00,.0 0,.% G.-Compressor Station Structure,0,,,,,,0,00,.0,.0 (,) (,),0.0% G.-Meas & Reg Station Structure,,,,0 0.,. 0,.% G.-Other Storage Structures,,0,,0,0,,0,,. 0,. (,) (,),.% G.-Leaseholds & Rights,,00,0,,0, 0,0,0.,. 0,.% G.-Well Construction,,,,0,,,, 0,,.,. (,) (,),,.% G.-Well Equipment,0,0,,,0,,0,,,.,. 0,.% G.0-Lines,,,,,,,,,,.,. (,) (,),0.% G.0-Compressor Station Equipment,0,,,,,,,,0,.,0,. (,0) (,),,0.% G.0-Measuring & Regulating Equip,0,0,,,0,,0,,.,0. (,) (,0) 0,00.% G.0-Purification Equipment,,0,00,,,,,,0,.,.0 (,) (,),.% G.0-Other Storage Equipment,0,,,,,,0 0.,0. (,) (,0),0.% G.-Rights of Way,,,,,,,,.,.,.% G.0-Structures and Improvements,0,,,,0,00,00,0,. 0,. (,) (,) 0,.% G.0-Mains,, 0,,,,,,0 0,0,.00,,0. (0,) (,),,0.% G.0-Compressor Station Equipment,,,, 0,0,,,,, 0.,00,. (,) (,0),0,.% G.0-Measuring & Regulating Equip,,,0,,,,,,,.,. (0,) (0,),00,0.% G0.0-Communication Equipment,,,,,,,0,,0.0,. (,) (,0),.% G.0-Other Equipment,,,,,, 0,,. 0,0. () (),.% G.-Rights of Way,,,,,, 0,,.0,. 0 0,.% G.0-Structures and Improvements,,00,,0,0,,,,. 0,. (,) (,) 0,.0% G.-Mains - Bare,0,0,,,,,,,.0,0. (,) (,),.% G.-Mains - C & W,,0,,00 0,,0,,0,,0.,,. (0,0) (,),,0.0% G.-Mains - Cast Iron,,,,,,,0, (,) (,) % G.-Mains - Copper,,0,000,0,..00 (0) () 0.0% G.-Mains - Plastic,,,,,,,, 0,,. 0,,.0 (,) (,) 0,,.% G.0-Measuring & Regulating Equip,,0,,,,0,,0,0, 0.0 0,. (,) (,),00,.% G0.-Services - Bare 0,,0,00 0,0,.,.0 (,) (,),0.% G0.-Services - C & W,, 0,0,,,0,0,,,.,. (,,) (,,),,.% G0.-Services - Copper,,,,,,,,,,. 0,. (,,) (,,0),0,.0% G0.-Services - Plastic,,,0,,0,,,,,.,,0. (,) (,,0),,.% G.0-Meters,, 0,, 0,, 0,,.,,. 0,00,,,0.% G.0-Meter Installations,,0,,,,,0,,,.,,. 0,,.% G.0-House Regulators,,,,,,,0,,,.0,. (,) (,),,.0% G.-Rights of Way, 0, % G0.0-Structures and Improvements,,,,,,0,0,,0,.00 0,. (,) (,),.0%.0 Office Furniture And Equipm Total,0,0,, 0,.,. () (),.%. Computer Equipment Total,,,,,,,,,. 0,.,,,.%.0 Stores Equipment Total 0,0,, 0,0 0.,.0,.%.0 Tools Shop And Garage Equip Total,,0,0,0,,0,,,.,.,,,.%.0 Laboratory Equipment Total,,, 0,0.0,.,,0,0.% G.0-Power Operated Equipment,,0,0,0 0,,.,.0,0,,.%.0 Communication Equipment Total,,0,,,, 0,,.0 0,., 0,00, 0.%.0 Miscellaneous Equipment Total 0,,, 0 0,0.0,.,.% Total,00,,00,,,,00,,00,,. (,0,),0,