XX. Depreciation - SoCalGas and SDG&E

Depreciation is the ratemaking and accounting process that allocates capital expenditures included in rate base to an expense, depreciation expense, which is recoverable in test year rates. The effect of depreciation is to allocate the large cost of assets over their full useful life. As a result, over time, the recovery of annual depreciation expenses in retail rates ensures that ratepayers are paying a reasonable allocation of the full cost of plant and equipment necessary to provide service to them. The details become very complicated; identifying the proper useful lives of numerous classes of assets and the millions of individual assets involved, dealing with changing estimates in any salvage or removal costs, and any other necessary adjustments. All retirements of plant affect the accumulated depreciation balance, so that over time, all investment is recovered regardless of actual service life.

In this section, we make appropriate adjustments to the depreciation requests of SoCalGas and SDG&E to reflect the Test Year 2004 rate base as adopted in this decision, and we address two other issues regarding net salvage value and the treatment of land rights.

A. Simple Example of Depreciation

Depreciation for SoCalGas and SDG&E is calculated separately for individual types of assets and for each generation of assets; for example, distribution-level pipeline would be tracked by type, size and vintage, and the Commission uses a "straight-line" method over the expected remaining life. To illustrate, (ignoring all other assets over time) if pipeline equipment costing $100,000 is installed in Year 1, and it is expected to last 10 years, depreciation would be $10,000 per year ($100,000/10 years original life). If the depreciation is reviewed at Year 5, and it is likely that the pipeline equipment will last not just the remaining five years, but will really provide service for another 10 years, then the remaining investment of $50,000 ($100,000 less the first five years' depreciation at $10,000 each) is now depreciated at $5,000 per year ($50,000/ 10 years remaining life). Depreciation expense would be reduced in rates to reflect the longer remaining life to recover the un-depreciated cost.

B. Remaining Life Estimates for SoCalGas and SDG&E

ORA examined for both SoCalGas and SDG&E the utilities' detailed studies for the assets in service, and there was no dispute on the results of those studies.²³³ In fact, the results are to generally lengthen the remaining lives. Therefore, due to this one factor alone, depreciation rates are lower, and thus the expense estimate declines for Test Year 2004, essentially as illustrated above, when compared to using the older depreciation rates. The applicants' witness testified that the remaining life studies were consistent with the Commission's Standard Practice for depreciation.²³⁴ We find the remaining life studies to be reasonable and adopt the results of the studies using them to calculate this portion of the test year depreciation expense after recognizing all other adjustments to the rate base before depreciation.

C. Simple Example of Net Salvage

ORA disagreed with SoCalGas and SDG&E about one further component of depreciation that recognizes the cost of removing old plant, less any salvage value. Again, a simple illustration is useful; if the same hypothetical $100,000 of assets in Year 1 was expected to cost $12,000 to remove from service and it would be worth $2,000 for scrap in Year 10 at the end of the service life, then the "net salvage" cost would be $10,000 ($12,000 - $2,000). To recover this expected net salvage cost, the utility would add $1,000 to annual depreciation expense ($10,000 net/10 years original life). So the total cost for both depreciation and net salvage in Year 1, for this one asset example, would be $11,000 ($10,000 plus $1,000).

D. Net Salvage Estimates for SoCalGas and SDG&E

ORA disagreed with the results obtained by SoCalGas and SDG&E when they used the method of calculating net salvage costs that the companies identify as the Commission's adopted method. SoCalGas and SDG&E used the method (for both remaining life and net salvage) described in Standard Practice U-4 Determination of Straight-Line Remaining Life Depreciation Accruals (Standard Practice U-4) adopted in 1961.²³⁵ SoCalGas and SDG&E calculated net salvage as a percentage of retired plant costs.²³⁶ The entire prepared testimony for SoCalGas in Ex. 16 is 10 lines, its rebuttal in Ex. 91 runs to four pages. (Unlike the simple illustration above, it is not specifically shown in detail in the testimony.) There were detailed workpapers and data responses that are not identified as exhibits. For SoCalGas, the last time the calculations for depreciation rates and net salvage rated were adopted was for Test Year 1994 in D.93-12-043. Since that time, the rates were not changed and the company's retail rates charged to customers have changed only as a result of the performance-based ratemaking in place and not because of a review of depreciation rates before the Commission.

ORA disagreed with the outcome of applying Standard Practice U-4; ORA argued that the method as applied by SoCalGas and SDG&E does not track net salvage by vintage year (year of installation) and the estimated cost of removal is overstated, and also arguing that actual costs of removal have been far lower than the allowance for net salvage included in rates.²³⁷ ORA's solution was to leave in place the old (lower) net salvage rates and adopt the new (lower) depreciation rates.²³⁸ SoCalGas, for example pointed out that the studies result in a $46.5 million decrease of depreciation and a $7.6 million increase of net salvage for a revenue requirement reduction of $38.9 million.²³⁹

If Standard Practice U-4 truly produces perverse results then we need to develop a recommendation on how to revise or replace the practice for the future. ORA argued SDG&E's actual costs for 1996 through 2001 were $13 million but the old rates generated $45 million. If accruals are too high, then current ratepayers might over-contribute to the total recovery of depreciation plus net salvage compared to later ratepayers; creating a timing problem between generations, if the difference is material. SoCalGas and SDG&E will not over-recover in total because ultimately they will never collect more than the original cost of every asset and the actual costs of net salvage. Leaving in place the old rates for net salvage to achieve a lower estimate is not reasonable. We direct SoCalGas and SDG&E to meet and confer with ORA, TURN and UCAN in advance of filing the next rate case and propose in that application any necessary up-date to the methods used to forecast depreciation and net salvage.

We will adopt the salvage rates as calculated by SoCalGas and SDG&E; the methods are reasonable and in compliance with the existing standard practice, to do otherwise would be "cherry-picking" the downward portion of the results of the new studies and selectively using the lower effect of the old rates.

²³³ ORA opening litigation brief, pp. 236-240. See also Ex. 302, p. 25-3 where ORA agrees to use the new study for its forecast of depreciation.

²³⁴ Ex. 16, p. REL-1, reference to Standard Practice U-4, Determination of Straight-Line Remaining Life Depreciation Accruals. See also, Transcript pp. 1,814, line 3 through p. 1,815, line 11.

²³⁵ Ex. 16, p. REL-2.

²³⁶ Transcript p. 1,835, lines 3-12.

²³⁷ Ex. 302, p. 25-8.

²³⁸ Id.

²³⁹ Ex. 91, p. REL-2.