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The replacement basis of depreciation in the regulation of rates of privately owned utilities Lee, Ming Chong

Abstract

Economic regulation of business activities appears to be contrary to the philosophy of free enterprise. It can be justified only if it is imposed as a means to serve the public interest - to enhance the economic welfare of society - when the self interest of the producer is likely to prove harmful to the general interest of society. Public utilities are enterprises which have to be regulated in the interest of society and particularly the rates they may charge. In the regulation of utility rates, cost is often accepted as the proper basis for fixing the rates. Among the costs of rendering a utility service is the cost associated with the use of a capital asset, that is, depreciation expense. There are various bases on which depreciation expense is computed. Thus, there arises the problem of selecting a proper basis for determining the depreciation expense that is consistent with the purpose of rate regulation. An examination of current literature suggested that there is a case, on theoretical grounds, for adopting the current replacement cost approach to depreciation accounting when the purpose of fixing a utility rate is to serve the interest of society. The case appears strong when a marginal-cost standard is accepted for rate regulation since, under the assumption of continuity of operations, the cost of replacing the services of a capital asset is the long-run marginal (opportunity) cost of employing the asset in the enterprise; thus, a rate that is fixed on the basis of current replacement cost will promote optimum allocation of resources in the economy. Even if a "full-cost" standard is employed in the regulation of utility rates, there is still a case for determining depreciation expense on the basis of current replacement cost. A utility rate that is fixed on this basis is more comparable to the price charged in the non-utility sector of the economy and, thus, promotes better allocation of resources between the utility sector and the rest of the economy. It also provides the enterprise an opportunity to maintain intact its productive capacity if this is in the interest of society; for the ability of the enterprise to continue production in the future will not be impaired. It is recognized that there are practical problems associated with the application of the proposal to a real life situation. However, they are not insurmountable. They appear no greater than the problems associated with the use of reproduction cost new - a concept which has been applied in practice in the history of rate regulation.

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