How Water Works Valuation Affects Rate Making
General Theory of Water Rates—What is Fair Valuation?—Depreciation in Theory and Practice—Overhead and “Going Value”
IN the following paper Mr. Saville treats of a subject that is of interest to practically every water works man. He has gone into the matter very thoroughly and his ideas will be found of value to those who are wrestling with the problems of rate making:
The matter of Rate Making or adjustment of rates for public water service has gradually become of much importance in the public mind during the past few years, because of the entrance of reasonable and definite methods of payment for value received, and recognition of increased cost of service. The basic principles of rate making for water supply utilities whether publicly or privately owned are the same but there are wide divergences thereafter. Utilities under public ownership have for their stockholders their own customers for the most part and usually these are to a great extent also the tax payers of the community served. What they propose to pay, how they propose to pay it, and what they propose to do with the income derived from the sale of water has been held somewhat immaterial so long as proper provision was made to take care of outstanding debts and bond issues. The consumers are the owners and within legal limits they may do as they like with their own.
Case Different with Privately Owned Plant
With privately owned plants supplying a community, the case is an entirely different one. The plant has been installed and paid for by private capital for the purpose of supplying a need that the consumers required but which they were unable or unwilling to provide from their own resources. This plant has been brought into being by private effort and the funds invested therein should be as sacred and inviolable as those invested in other property or deposited in savings banks. The funds that have been used to install a water utility have been placed there as a business investment by their owners, and they have a right to expect a reasonable return upon the investment.
“In valuations for rate making the fair value of the property for that purpose and no other is being sought. There are no cut and dried formulae that can be applied and the answer ground out; judgment tempered by experience is the ultimate key to the problem.”
General Theory of Rate Making
In the consideration of rates or charges for such service the older idea was that of worth or value to the user or consumer and along this line was developed the principle which was epitomized in the phrase “all the tariff will bear.” All the tariff will bear, however, may have two meanings entirely different in their application; it might mean as high a rate as could be gouged out of a needy applicant or it might mean the least that the purveyor could afford to charge for delivery of the commodity. This latter theory has gradually merged into the more modern plan of rates established on the basis of cost of service; that is, the reasonable amount that the producer can afford to sell and the consumer afford to purchase the given commodity. What this “reasonable” amount is, however, is the rock on which many perfectly good attempts on both sides to get together, have been wrecked.
There is no advantage to the producer in advancing rates to such a point that the majority of customers are unable to pay the price and on the other hand there is no incentive for a business concern to enter upon or to continue in a business that is being run at a loss. For private enterprise dealing in ordinary goods the rate of charge is a personal matter between individuals, for the customer can go elsewhere if he is dissatisfied and the dealer has no assurety against competition.
Both Protected by Public Utilities Commission
Semi-public enterprises, however, which are concerned with the necessities of life or at least with the general comfort and convenience of large bodies of people when under private operation must be more or less of a monopolistic nature in order to function or attract the necessary capital. With these the rights of the public who have given the franchises and the interests of those who have invested private capital to meet a public need, both must receive protection, the one from the other, in case of dispute as to “reasonable” or fair return, on the money invested and on the work required to run the business. To deal with matters of this kind in an impartial way public utilities commissions or similar bodies have been created in the different states. These commissions are semi-judicial as to their action but their findings and orders are always reviewable by the established courts of the country, whose duty it is to interpret the law and to decide whether or not an injustice has been done to either side in the controversy.
In the case of Smyth vs. Ames (169 U. S. 466) the principles are stated which have since become a basis of procedure in so-called rate cases. Summarized the opinion stated that, (a) The utility is entitled to a fair return on the fair value, and (b) The public may demand that the charge for service be no more than it is reasonably worth, in other words, “fair value” is that value the return on which produces a “fair return” on the cost of the service. It is plain that a fair return on the cost of service must include interest on the invested capital, depreciation of the plant used for the service of the public, insurance and taxes, cost of maintenance and a fair rate of profit on operations.
What is Fair Valuation?
In deciding the fair rate of return the first question to be answered is what Value shall be given to the plant ? Valuations of physical property are made for many purposes and anomalous as it may seem, a different figure will probably be arrived at in each case, resulting from consideration of the particular purpose for which the valuation is made.
A valuation for establishing rates or for use in condemnation of a water plant by a municipality will arrive at a different figure than one made for use in negotiations between a city and a water company’ to determine the worth to the city, and these two may differ from a third amount for use in application for mortgage, for issue of capital stock or for taxation purposes. For example, for rate making purposes valuations may not include cost of replacing pavements over main pipes that have been laid since the pipes were installed, as this work has entailed no expense on the company; on the other hand, in a valuation for negotiations to determine a reasonable sale worth, it is clear that the cost of removing and relaying all pavements must be considered in arriving at the cost of installing a duplicate plant.
In valuations for rate making, as has been stated above, the fair value of the property for that purpose and no other is being sought, and while there are many methods by means of which attempt has been made to arrive at the desired goal, all of them can he but indices, more or less useful in guiding the judgment of the appraiser and to indicate to the court or commission the road by which the appraiser has travelled. From these it can be decided if the results obtained present a reasonably close approximation, for the purpose in view, of the actual value of the plant. There are no cut and dried formulae that can be applied and the answer ground out; judgment tempered by experience is the ultimate key to the problem.
As a matter of fact court decisions from the Supreme Court of the United States down have very closely circumscribed and limited the fundamental bases on which valuations for rate making shall be established, and the several public utility commissions follow the lines thus established. Among the methods used in valuating property for rate making, but by no means being given equal weight are:
Legitimate investment or cost actually shown by the books of the concern, including deficiencies of net income below a fair return.
- Estimated Cost of Reproduction of the plant used and useful for water supply purposes, less depreciation, plus certain intangable items inherent to similar investments.
- The present worth of the net revenues of the company determined from a prediction of probable return from a long period into the future, say 30 or so years, often gives a very excellent check upon other methods.
“Cost” and “Value” not Synonymous
At the outset it is well to remember that “cost” and “value” are not synonymous. Cost is the price paid;
Value is the intrinsic worth at the time and for the purpose that the article is desired. In many discussions of valuation methods the term “fair average price” is used. Coming down to “brass tacks” so to speak, this term is very deceitful. No one knows what is meant by an average price for any commodity and the opinion of even competent observers based on such a figure can in the end but lead to values which are more or less speculative and so not in good standing in court.
In a rate making case there is always present the element of confiscation whereby personal rights guaranteed under the constitution of the United States may be violated, if “private property be taken for public use without just compensation” (Art. V, Amendments to the Constitution of the United States). By decisions of the highest courts of the country it is the value of the property at the time of the inquiry and not original cost at some remote past nor whether or not original investments and vouchers were wisely or perhaps even legitimately made that must be considered.
The United States District Court of New York (Hand. J.) has held specifically that reproduction new at the time of the inquiry, properly depreciated to represent present conditions, is the basis on which to compute rates, and declared that such a conclusion was entirely justified from a consideration of the decisions of the Supreme Court of the United States. (Consolidated Gas Co. vs. Newton, 267 Fed. 231.)
In the Minnesota Rate Case (230 U. S. 252) the Supreme Court (U. S.) said: “If the property which legally enters into consideration of the question of rates has increased in value since it was acquired, the company is entitled to the benefit of such increase.” The value of the plant must be ascertained “as is” and not as present good judgment might dictate, for there again a labyrinth of speculative paths open up which must be avoided; the only safe road is that hewed out by the original builder of the plant, who unless otherwise proven, must be assumed to have acted in good faith throughout.
Depreciation in Theory and Practice
Having arrived at the fair cost of reproduction new of an equivalent plant “used and useful” for the water supply purpose at hand, an estimate of the present worth of the various parts of the actual plant can be made.
This value is ascertained by the exercise of good judgment, coupled with experience in water supply work and guided in some degree by consideration of certain factors that general observation has found to represent that that reduction in value known as depreciation.
Theoretically a property begins to depreciate the moment it is completed. That every part of every plant depreciates with age is axiomatic, but that the same part of all plants depreciates at the same rate is not in accord with known facts. For this reason there can be no concise general rule for determining depreciation.
(Continued on page 806)
How W. W. Valuation Affects Rate Making
(Continued from page 786)
Depreciation may be due to several causes. Generally it may be classified as physical, functional and contingent. By physical depreciation is meant the gradual wearing out due to use even where the best of upkeep attention is provided. By functional depreciation is meant the liability to give required service due to obsolescence when no further repairs or expenditures can make the structure able to compete efficiently or economically with those more recently designed which have the advantage of new inventions or machinery.
Contingent depreciation includes such losses in value of the plant as may not logically be placed in the other two classes, such as extraordinary replacements due to changes that can not be foreseen, for example, radical changes in the grade of streets, whereby it will be necessary to relocate water pipes; early abandonment of wells due to change in the character of the water; possibly also rare expenses due to unusual or unseeable conditions, as the bursting of large water mains, destruction of reservoir dams due to cloudbursts, and similar happenings, the expense of repair of which may fairly be spread over a term of years, may be placed in this account.
In most states utilities under the control of a commission are required to carry a proper depreciation reserve along with their other accounts. The amount of this charge must take into account the life of each separate piece of equipment, its value new and the amount, if any, of its “scrap value.” The estimate of the annual amount required to make up the depreciated plant value is commonly estimated by one of two methods, i. e., the so-called “sinking fund” method and the “straight line” method. The endeavor is made to keep such a balance between depreciated plant value and depreciation reserve that at any time the sum of these will equal the investment which has been made in the plant.
Under the straight line method an equal drop in value is made for each year of assumed life of the item while under the sinking fund method the drop is light during the first years and increases gradually toward the end of the assumed life of the article or structure.
The sinking fund method seems to more nearly correspond with the actual course of decay in the life of the parts of the plant. Under the sinking fund method it is assumed that the annual amount set aside for replacement will, if invested at compound interest (usually about 3%), plus interest, amount in the given time to the investment value of the depreciated unit.
In his paper “Practical Checks on Water Works Depreciation Estimates” Leonard Metcalf gives eleven Complete records, which with some other data and the omission of abnormal results show an average of 20.7% and a range of from 13.3% to 27.0% as the amount of accrued depreciation on plants evaluated by him.
Principal Overhead Expenses
In the evaluation of utility property constructed many years ago when the desirability of having accurate records was not as well recognized as at present, many cost items either were overlooked entirely or only partially recorded. Some of these items are in the nature of “overheads” that is, matters of real value to the con-
struction of the plant, but of such a character that it is hard to give definite estimation of them. In order to include these in the value of the plant, it is customary to use percentages of the cost of the work or the reproduction estimate, based on study of local conditions.
Among the principal “overhead” expenses which sound judgment and experience have shown should be included in the capital cost of a plant are the following which have been worked out as a general average:
For a general discussion of overhead allowances, reference is invited to the Indianapolis Water Case Public Utility Reports 1923 B. p. 474.
“Going Value” Essential in Valuation
Another item of value of an intangible character is that known as “Going Value” or the value of an established business over a plant completed but not yet in service. “Going Value” must not be confused with “Good Will” for they are by no means synonymous terms, as has been indicated by both courts and commissions in allowing the former but discarding the latter as part of a valuation schedule.
That “Going Value” is an essential element in the determination of the value of a public utility property is not now open to question, because of the many court and commission decisions. In the case of the Duluth Street Railway Company (P. U. Rep. 1923 D. p. 727) the Wisconsin Railroad Commission said:
“We have in mind the fact that this company is in operation with a history of fairly successful operation for a considerable period of time and we have in mind also the facts that the courts generally have recognized that a property in operation and actually constituting a going concern has some value attached to the individual elements of which the property is composed.”
In the Spring Valley Water Company vs. San Francisco, Judge Brewer said (124 Fed. 574) that:
“It was obvious that the mere cost of purchasing the company’s land, constructing the buildings, putting in the machinery and laying pipes in the streets, in other words, cost of reproduction, did not give the present value of the property: that a completed system of water works without a single connection between the pipes in the stree_____s and the buildings of the city would be a property of much less value than that system connected with so many buildings and earning in consequence thereof the money which the company earned: that the fact that it was a system in operation not only with a canacity to supply the city but actually supplying many buildings in the city; not only with a capacity to earn but actually earning, made it true that the fair and equitable value was something in excess of the cost of reproduction.”
Fire Inspection Week in Des Moines—Fifty firemen. 100 inspectors and 50 Boy Scouts cooperated in making inspection week successful in Des Moines, la., from April 6 to 10. Among others who took part in the campaign was Harry Rogers, the fire clown.
Canton Has Light Fire Loss in March—The fire loss in the city of Canton, Ohio, according to Chief R. O. Mesnar. was unusually light, only one fire of 8700 fire loss and another of $500, being recorded. The other fires of the month were only trifling in loss. During the month 52 calls were received. Of this number 12 were box calls and 39 telephone calls giving the latter about eighty per cent of all the calls. Two of the box calls were false alarms and one of the telephone calls was false. There were 18 grass fires and one street car fire. Nineteen of the buildings were frame, three brick and frame one brick and stucco, two frame and iron and one brick.