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How do Utilities, Nuclear and Gas plants Return of Capital and Return on Investment works?

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sahel daqamseh's picture
Capital Cost and Planning Portfolios PSEG

I am a passionate Energy Professional, focused on the Cost and Financing side of Energy and Utility. I like to learn about and contribute to Bridging industries towards cleaner energy, Nuclear,...

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  • May 18, 2020
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Within the utility industry, the finance of their capital programs is the dictator of the companies five to ten years direction, as they utilize many funding and investment instruments, whether a publicly funded utility or a privately funded utility, the borrowed capital to execute projects to serve the public needs remains the most important factor for project executed.

Over the last century, electricity and clean energy have been at the forefront of U.S. priorities in meeting the public's energy needs. In each state, many companies provide energy under regulations issued by local state and government commissions. In New Jersey, power companies operate through the PJM interconnections (Pennsylvania, Jersey, and Massachusetts) [1] and are regulated by the Federal Energy Regulatory Commission (FERC) [2].

Local Jersey companies are extending capital throughout PJM with plans to carry out reliability projects, in order to better supply customers with electricity. The capital expenditures of local companies are in turn incorporated into the application for an increase in the base rate per $/kW.h (kilowatt.hour) that is charged to customers with the best electricity [1]. In this article, we will understand in more detail the important role of the cost engineer in such an industry.

 

Utility Financing:-

Now let's take a step back and take a look at how utilities fund their projects and how project reporting is done to meet financial requirements. First, we need to understand the return on investment (ROI) factors for utilities when they invest in capital projects, such as a substation or power plant.

 

Any utility company has a basic rate of return formula, that determines how they should charge per kW.h, which is based on multiple factors such as revenue requirement, rate base, which is the amount of capital or assets the utility dedicates to providing its regulated services, allowed rate of return, which is the cost the utility incurs to finance its rate base, including both debt and equity, operating expenses, which are the costs of items such as supplies, labor (not used for plant construction), and items for resale that are consumed by the business in a short period of time (less than one year) and annual depreciation expense, which is the annual accounting charge for wear, tear, and obsolescence of plant, lastly, all taxes not counted as operating expenses and not directly charged to customers. [1]

 

R ≡ B • r + E + d + T. [3]

R: revenue requirement

B: rate base

r: allowed rate of return

E: operating expenses

d: annual depreciation expense

T: all taxes

What we can derive from here, when a utility company, for example, invests in a new asset, it contributes to the company's revenues in two ways: first, through the revenues generated by the electricity produced and sold, once the asset is commissioned, and second, through capital expenditures, which are then accounted for in the company's base rate increase. To understand more about what’s included in the Base rate, refer to Robert Hahne & Gregory’s Aliff book, Accounting for Public Utilities, Pub. 16, release 36, 2019, chapter 4.04. These two tycoons of the accounting world in the utility industry, better explains for you, how utility companies make revenue and how capital expenditures feed into the company application for base rate increase.
 

 

 

Now, it is safe to say that the equation below is true, even if it is very simplified:  

 

 ROI of an asset = income from the sale of electricity + Base rate increase due to capital expenditures + Base rate increase due to other factors.

 

 


[1] 

https://bear.warrington.ufl.edu/centers/purc/docs//papers/0528_jamison_rate_of_return.pdf ”

                        2018

                        Page 5, “HOW RATE OF RETURN REGULATION WORKS?”

 

sahel daqamseh's picture
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Matt Chester's picture
Matt Chester on May 18, 2020

Interesting stuff, Sahel-- do you think that an overfocus on these metrics could lead to some utilities chasing sub-optimal projects? Or are they the most appropriate measures to be used and tracked? 

sahel daqamseh's picture
sahel daqamseh on May 20, 2020

Matt, yes, PJM (Pennsylvania Jersey, Massachusetts) Interconnection is the authority that will always dictate any capital work being a "Prudent Investing" for the company and to be vested in the base rate increase.

Roger Arnold's picture
Roger Arnold on May 20, 2020

The use of the terms "base rate" and "base rate increase" here is a little confusing -- at least it was to me, initially. 

In the equation for required revenue R, the "B" is the aggregate depreciated capital base. ( I.e., the total of what the utility has invested in the system less depreciation already taken.) "r" is the ROI allowed by the regulator. It's the same rate for any investment that's allowed by the regulator, regardless of actual merit. The price of electricity to ratepaying customers is whatever is needed to generate "R".

This is the naive regulated monopoly model for a utility. Valid criticisms for that model are that it does not incentivize innovation or smart control of expenses, guarantees the same rate of return on any approved investment (regardless of merit), and creates a lot of bureaucratic overhead in the approval process for all investments. It also opens the decision process to political influence and potential corruption. Naturally, in practice various patches have been applied with the intent of addressing those deficiencies.

I'm in no way qualified to comment on the detailed nature of the patches and how well they work. What I do know is that no system of written rules and procedures that involve people is so perfect as to function well if the individuals responsible for following those rules and procedures aren't motivated to make the system work. Conversely, no system is so imperfect that it can't be made to function if those operating it are competent and motivated to make it work.

There's just no substitute for competence and good will. The perpetual puzzle is not to define the perfect system, but to figure out how attract and reward the kind of people who will make it work.

sahel daqamseh's picture
sahel daqamseh on May 20, 2020

Roger, you are saying the right statement!

 

In the late 80s and 90s, companies where doing a lot of Capital investments in order to build them in the Base Rate, and that led to a rate inflate! The government shutdown 12 nuclear plants and started one of the biggest claims in the history in Georgia and Carolina's. 

That’s why there are authorities like PJM (Pennsylvania Jersey, Massachusetts) Interconnection is the authority that will always dictate any capital work being a "Prudent Investing” and a new rule came in place by that a company can’t build anything in the Base Rate increase until the facility is Generating Electricity.

My study is published at the AACE website and talk more and I am happy to connect with you further and give insights!

 

But you train of thoughts is amazing.

Roger Arnold's picture
Roger Arnold on May 20, 2020

BTW, the paper you tried to reference is a good one, but the reference is messed up. To get to it, I had to copy the text of the link (including the opening and closing quotes), paste it into my browser address bar, then edit the address bar to eliminate the quotes.

Matt Chester's picture
Matt Chester on May 20, 2020

Thanks for the note Roger-- I've gone ahead and updated the link for Sahel!

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