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Allowance for Funds Used During Construction, aka. Cost of Capital | Make this cost part of every electric project | Following this FERC best practice

Russ Hissom's picture
Owner Utility Accounting Education Specialists - utilityeducation.com

Russ is the owner of Utility Accounting Education Specialists a firm that provides power utilities consulting services and online/on-demand courses on accounting, finance, FERC best-practices,...

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  • Mar 26, 2021
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What does including the cost of capital in projects mean for utility rates?

This article is another in our series on utility construction accounting. We find that most investor-owned utilities, large utilities, and electric cooperatives follow the guidelines for electric construction accounting in the Federal Energy Regulatory Commission's Uniform System of Accounts (FERC USOA). At times mid-sized and smaller utilities (mainly municipal systems) leave some of the allowable costs of construction "on the table," i.e., not recording some costs as part of total construction costs. The impact of not including all costs will be felt in future years when it is time for asset replacement. A utility could find itself in the position of not having recovered the total cost of assets in customer rates, thus not generating sufficient funds to pay for the replacement of the related assets.

This article dives into the allowance for funds used during construction (AFUDC) or the cost of capital. 

      What is AFUDC?

AFUDC is the cost of capital, or more plainly, the cost of how money is spent. For example, a utility/coop could take $1,000 and spend it for utility personnel raises, new capital projects, research, maintenance, or leave those funds in the bank. Each potential use of the funds has an opportunity cost associated with it.

The AFUDC is an interest rate applied to the investment in each potential area. The calculation of the interest rate is found in the FERC USOA plant instructions Section 3. The calculation is based on the funding source and associated interest rate of each source.

For example, the utility has planned projects of $10 million. It will be financing that construction through a combination of sources as shown in Table 1:

Table 1 – Project Financing Sources

The calculation shows that the utility’s cost of capital (or AFUDC rate) for this year is 4.3%.

AFUDC rate application policy

Utilities and electric cooperatives have different policies on applying AFUDC based on the uniqueness of their operations. Some utilities apply the AFUDC rate to every dollar of spending on projects. Others apply the percentage to projects over a specific size and duration (e.g., applying AFUDC to projects of over $50,000 that take at least three months to complete). Our opinion is that “a dollar is a dollar,” and no matter when the dollar is used, or for what it is used, the opportunity cost (interest cost) is calculatable and should be included.

The impact of AFUDC

In Table 1, the AFUDC rate is 4.3%. Applying that AFUDC rate to the $10 million of projects will increase the total project costs (and thus the asset values) by $430,000 ($10 million x 4.3%). What is the impact of adding $430,000 in key areas that impact cash flows?

                       Depreciation impact

For our example in Table 1, let’s assume these are electric distribution projects. The typical useful life of electric distribution plant in service is approximately 30 years. The impact of adding AFUDC is shown in Table 2:

Table 2 – Sample Depreciation Impact of AFUDC

In our example, adding AFUDC to the balance of current year projects results in an annual $14,333 needed in rate recovery from customers.

Rate of return impact

Adding a typical rate of return to the calculation results in an additional $34,400 annual rate recovery requirement in customer rates, as shown in Table 3.

Table 3 – Sample Rate of Return Impact of AFUDC

Total rate impact

Why is this important? The amounts represent the cost of the capital committed for projects. The funds collected in rates would be used for the following purposes:

Table 4 – Total AFUDC impact on depreciation and rate of return

Not a significant difference? The $48,733 is the annual difference for just this year. If your utility/coop does not include AFUDC in projects, the calculation would be to layer this methodology on all projects done to date (from the inception of the year the utility/coop began to serve customers). The layering would compound the annual rate shortfall we’ve demonstrated by analyzing just the current year’s projects in Table 1. 

      Recalibration frequency                      

Interest rates are not static. At a minimum, the AFUDC rate should be calculated at least annually. The mix of resources used to fund projects varies from year to year and will impact the weighting of each financing source, and thus the weighting of the interest cost of that type of financing, i.e., short and long-term debt, stock, and internal reserves.  

      Summary

This article discusses the issue at a high level, but the application of AFUDC is not an overly complicated process. Overlooking this area of utility work order accounting will lead to a cash flow shortfall when it is time for asset replacement.

Russ Hissom is the owner of UAES, a company that offers online, on-demand utility accounting and business process courses, articles, and eBooks. We also present custom accounting courses for your unique utility or electric cooperative. You can reach him at russ.hissom@puaes.com. The puaes.com website has a wealth of articles, eBooks, and online resources that will benefit your utility’s accounting and customer ratemaking strategies.

 

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