Apple does not price iPhones on what they cost to build. Regulated utilities do.
Electric, gas, and water delivery are usually natural monopolies: one network of wires or pipes serves an area more cheaply than two competing ones. So the market doesn’t set a utility’s prices. A public utility commission does, in a rate case, starting from the utility’s own accounting numbers.
That process, and the accounting behind it, isn’t taught in a standard accounting curriculum. Here are the four things that surprise people when they land at a utility.
1. Profit is earned on investment, not sales.
The commission sets a revenue requirement (also called cost of service):
Operating expenses (including depreciation and income taxes)
+ Rate base x allowed rate of return
= Revenue requirement
Rate base is the utility’s net investment in plant that serves customers. Spend $28 million on maintenance and you recover it as an expense, but you earn nothing on it. Spend $28 million on new plant and it earns a return for decades. That second line is the incentive to build, and it’s why deciding whether spending counts as an asset or an expense matters more at a utility than almost anywhere else.
2. There’s a fourth set of books.
Most businesses use their accounting software to produce three “sets of books”: GAAP for investors, tax for the IRS, and management reports for the people running the company. A regulated utility keeps a fourth: ratemaking, the numbers the commission uses to set rates. Rate base, regulatory assets, and the unique deferred tax treatment all live in that fourth set. Only regulated utilities do this.
3. The balance sheet has items no other industry has.
The concepts below would look strange to most business people, but at regulated utilities they are critical to balancing the need for fair rates with incentives to invest in new infrastructure or safety measures.
- Regulatory assets: costs the utility carries as an asset because the commission is expected to let it recover them in future rates. Almost anywhere else, they’d be expensed.
- AFUDC (allowance for funds used during construction): the cost of financing a plant while it’s being built, added to the plant’s cost and booked as non-cash income.
- Normalization-driven deferred taxes: federal rules make utilities pass the benefit of accelerated tax depreciation to customers slowly, over the life of the plant, instead of all at once. The difference piles up on the balance sheet.
4. Open books.
Around 1907, starting in Wisconsin and New York, utilities accepted a deal: exclusive territory, in exchange for commission control of prices and accounts the regulator could read. Part of the reason was accounting and finance shenanigans, like issuing stock worth far more than the plant behind it. Uniform accounting was the fix. The results of that regulatory accounting are what get debated in every rate case today.
Most countries run their utilities as government agencies. In the US, with deep roots of capitalism, private companies own the wires and pipes, and commissions set the prices and read the books. The result is utility service that is reliable, fair, and accountable.
You don’t have to be an accountant to need this.
Every rate case, plant retirement, storm-cost recovery, and data center interconnection is argued in these terms, and the engineers, attorneys, and project managers in the room are expected to keep up. A lawyer at Hawaiian Electric wrote after our seminar: “As a lawyer, I was deathly afraid of the workpapers & spreadsheets in our rate cases. Dr. Berk explained the numbers & concepts in an easy-to-understand manner.” (Dr. Berk is my dad, Joel. Our self-paced courses are still taught by him.)
Our courses help create common vocabulary and a foundation of how regulated utilities make money.
FAI has taught utility finance and accounting courses since 1982. One seminar is now a self-paced online course: Utility Finance and Accounting for Non-Financial Professionals.
Kevin
PS – Someone on your team just joined the utility and is still decoding this? Send it over.