THE LIBRAPvY
OF
THE UNIVERSITY
OF CALIFORNIA
RIVERSIDE
Public Utility Rate Fixing
COMMENTS
on Current Problems Pertaining to
PUBLIC UTILITIES
and to
RATE FIXING
By
C. E. GRUNSKY, Eng. D.
Consulting Civil Engineer
Member Am. Soc. C. E.; President American Engineering Corporation ;
President California Academy of Sciences ; Author of " Valuation
Depreciation and the Rate Base," "Topographic Stadia
Surveying," etc.
TECHNICAL PUBLISHING COMPANY
SAN FRANCISCO
1918
Copyright 1918
by
Technical Publishing Company
PUBLIC UTILITY RATE FIXING
THE 1918 TECHNICAL SERIES
Public Utility Rate Fixing
By C. E. Grunsky $2.50
Elements of Western Water Law (revised)
By A. E. Chandler $2.50
Elements of Fuel Oil and Steam Engineering
By Robert Sibley and Chas. H. Delany $3.00
TECHNICAL PUBLISHING COMPANY
Crossley Building, San Francisco
CONTENTS
CHAPTER I Page
General Comments on Rate Fixing 1
Accrued depreciation should not affect rates The rate base
and the natural rate base Legitimate earnings The Knox-
ville Waterworks case with reference to past history of public
utility, ordinary assumption that capital has been retired not
justified Adequate earnings include profit Gross annual in-
come as basis for profit allowance The replacement require-
ment Accrued depreciation non-essential in rate fixing
The bonus and the rate base Cost and value of water rights
in their relation to the rate base-^Appreciation in relation to
the rate base Illustrations showing practical application of
some fundamental principles Investment as a rate base con-
trasted with value Interests of the owner, the rate payer
and the public Difficulty of ascertaining depreciation.
CHAPTER II
Elements Deserving Special Consideration When Rates
are to be Fixed 34
A. Obsolescence 34
Obsolescence cannot be predicted Treatment of obsolescence
and replacement compared Obsolescence should affect rates
after, not before the event Illustration.
B. Losses from Fortuitous Events 39
Amortization of losses from fortuitous events.
C. Hazard, Management and the Unearned Increment 41
The allowance for hazard for the unearned increment and for
management should not be based on value Volume of busi-
ness to be considered.
D. Volume of Business 46
Public utility rates and the volume of business.
E. Going Value 49
Going value in the San Francisco water rate case Determina-
tion of going value Cost of establishing business is not
going value Going value the result of earnings.
CHAPTER III
Appraisal of Real Estate Adapted to Special Use 59
The value of reservoir lands Circumstances affecting the value
of land -Factors to be considered in determining the market
value of reservoir land Appreciation of land value Increas-
ing land values in the San Francisco Bay region Tables and
diagrams showing population and real estate valuation in
California and the San Francisco Bay region Court decisions
on reservoir land value in the San Francisco Bay region.
CHAPTER IV
Determination of the Value of Real Estate in Eminent
Domain Proceedings 81
All possible uses must be considered -Reference to court decis-
ions The value multiple.
CHAPTER V Page
Depreciation and Appreciation 90
The depreciation problem Mathematical demonstration of defi-
ciency of ordinary formulas Determination of the current
replacement is essential Appreciation in relation to rates
Appreciation referred to in court and Public Service Commis-
sion decisions The Interstate Commerce Commission has diffi-
culty in dealing with appreciation Treatment of Depreciation
and appreciation compared.
CHAPTER VI
The Value of a Water Right 101
Recognition of value Regional cost of development consid-
ered Strategic value Water power development should be
encouraged The life of the right affects its value Earnings
create value The San Francisco rate case Comparison with
other water rights Mutual water company stock sales as an
aid in determining the value of water rights The enhanced
value of irrigated land in relation to the value of water
rights The obligation to supply water at less than cost.
CHAPTER VII
The Rate of Return 121
Protection of the investment Other factors besides the rate
of return on the legitimate investment Rate of return de-
fined The obligation of the public when it regulates Rate
of return illustrations The Spring Valley Water Company
rate case.
CHAPTER VIII
The Rate Schedule 135
Unit prices to consumers not uniform Some problems for
consideration The unearned increment as a factor Determin-
ing factors- The remission of taxes Rates for electric
energy Gas and Water rates Street oar fare The zone sys-
tem Essentials in street car operation The railroad rate
schedule- The long and short haul question Artificial com-
petition with water transportation The government owner-
ship problem.
CHAPTER IX
The Public Utility Rate Base . 151
Value as a rate base illogical The natural rate baso- Restric-
tions imposed by court decisions Appreciation and the rate
base.
CHAPTER X
Fair Value and the Rate Base, by C. E. Grunskv, Jr.,
Capt. U. S. X. A .: *. 156
Special committee of Am. Soc. C. E. on "fair value" and "fair
return" Functions of rate fixing authorities and of courts
not the same The use of value when fixing rates imprac-
ticable A satisfactory rate base The present situation.
Index 165
PREFACE
A number of articles dealing with the problem
of fixing public utility rates and related matters,
originally contributed to the Journal of Electricity,
have been assembled in this volume. One, by Capt.
C. E. Grunsky, Jr., entitled "Fair Value and the
Rate Base" has been included and will be found at
the end of the volume. As these articles are here
reproduced from the original plates, this fact will
sufficiently explain what might otherwise be classed
as too frequent repetition of certain fundamental
truths, such as the statement that it is illogical to
make "value" which results from the earnings and
therefore, too, from the rates, the basis of the calcu-
lation when rates are to be fixed. That some of the
ideas here presented may prove helpful to those who
are engaged in determining fair rates for the output
of public utilities or in prescribing methods of pro-
cedure when rates are to be fixed, and that, the war
having ended, this little volume may assist in the
solution of some of the economic problems which will
arise in the readjustment of affairs to peace condi-
tions, is the hope of the author.
C. E. GRUNSKY.
San Francisco, Cal.
December 1, 1918.
There is no public rcsn
Its utilization conscrv
i-Mcouraeed hy liberal
control by the KOVITIHI
lion and the consumer
rce more worthy of early development than water power.
* the nation's fuel supply. Private capital should he
erms which can be done without surrendering ultimate
nt in the interest nf the public. Society demands ulili/a-
can afford and is willing to pay the rates.
PUBLIC UTILITY RATE FIXING
CHAPTER I
GENERAL COMMENTS ON RATE FIXING
The writer has recently been asked to define his
views on the rate regulation of public utilities with
special reference to the earnings which should be
allowed to the public utility corporation. In doing
so he will, for convenience, refer to and quote in a
limited measure from some of his publications on the
subject of valuation for rate-fixing purposes and re-
lated matters.
For 25 years he has had to give more or less atten-
tion to rate regulation and his views on some of the
more important features to be considered were definite-
ly crystallized when as city engineer of San Francisco,
1900 to 1904, he made appraisals of the properties of
the Spring Valley Water Company. He was from
the outset so firmly convinced that accrued deprecia-
tion is not an element for consideration when rates
are to be fixed that he has at all times adhered to
this principle and in 1912 he contributed to the Amer-
ican Society of Civil Engineers 1 a paper on "The Ap-
praisal of Public Service Properties as a Basis for
the Regulation of Rates," to demonstrate its sound-
ness. He found it desirable, for the benefit of the
profession, to do this, because the rate regulating
authorities were generally accepting without protest
the view, laid down by the courts, that "value" must
be the basis of the calculation when the sufficiency of
a rate is in question. Concerning the above paper
of 1^12, the theory laid down in which has gone un-
challenged, Mr. J. \V. Alvord says 2 :
'Transactions Am. Poc. C. E. Vol. KXXV, p. 770,
'Transactions Am. Soc. C. E. Vol LXXIX, p. 232.
2 PUBLIC UTILITY RATE FIXING
"The question of deducting depreciation from cost new,
however, is fundamental to a proper value, and, as a matter
of fact, for the past 15 years, engineers and attorneys have
been arguing for its deduction, and courts have been ap-
proving the practice of subtracting the depreciation from
reproduction cost new in every case brought before them,
without a single exception which the writer can recall. En-
gineering appraisal boards, so far as the writer is aware,
have pursued the same practices. In water-works appraisal,
the question was discussed and settled more than 15 years
ago, and has never been seriously controverted since, until
Mr. Grunsky's paper * * * appeared in 1912, before
this Society."
It is self evident that the service rendered by,
or the output of any public utility does not deterioate
as the result of aging of the plant. If there is any
change, the advantage should be with the long estab-
lished plant which should render a more dependable
and better service than a new plant. The value to the
consumer of the service or of the output is in no
way affected by the accruing depreciation. It is as-
sumed of course that a well maintained plant is under
consideration which shows no deferred maintenance.
Accrued Depreciation Should Not Affect Rates
The establishment of rates, therefore, should be in-
dependent of accrued depreciation. The rates found
to be proper for a new plant should be equally appro-
priate for a plant which has been long in service. It
follows that some other procedure is desirable than
the one which has apparently been laid down by the
courts.
Furthermore, it is illogical to require that value
in any form be made the starting point when rates or
reasonable earnings are to be determined because
value is a result of the earnings and can not be made
a premise. The courts make inquiry relating to value
because they are concerned in determining whether
or not the earnings are adequate to protect the value.
The rate-fixing authorities, on the other hand, are free
to use any method that to them seems proper in de-
termining the required earnings of any public utility.
They need not apply the value test. They should,
GENERAL COMMENTS 3
moreover, adopt the simplest and most direct method
of procedure. This the writer has repeatedly pointed
out, but finds it difficult to make plain to the old
line economists and valuation experts, that as a
starting point, despite the decisions of the courts, a
rate-base can be used which is not value. Even Mr.
Alvord assumes that the writer's appraisal of a rate-
base undiminished by depreciation represents value.
A clear distinction should be made between the writer's
"natural rate-base" determined from legitimate invest-
ment, for example, and the "fair value" or "present
value" which is so commonly used as the starting
point. Although so-called "fair value" has been very
generally used as a rating base, this does not mean that
rate-base and value should be regarded as synonymous.
The rate-base may be quite as distinct from value
as original cost is distinct from value.
The Rate-base and the Natural Rate-base
To make this clear it is necessary to keep in mind
that the rate-base is any sum to which a rate of in-
terest is applied in determining the interest increment
which should be covered by the earnings.
For example in the case of a steamboat, whose
owner may have made no other investment of capital
than in the steamboat, the service rendered to those
who ship freight on the boat or who travel on the same
is worth no more nor less if rendered by a new boat,
than if it were rendered by a boat which has already
been in service one-half of its probable life term.
The natural rate-base in this case is the amount
invested in a new steamboat or, expressed in the usual
way, the legitimate investment, undiminished by de-
preciation. On this rate-base the owner will be en-
titled to interest at a fair rate covering at least the
amount which a responsible owner would have to
pay for borrowed money and he will also be entitled
to such renewal or replacement increments as will,
if held inviolable for this purpose, replace the steamer
with a ne\v one when it ceases to be useful. But if
the owner were not allowed to earn more than these
4 PUBLIC UTILITY RATE FIXING
interest and replacement increments in addition to
cost of operation, he would not be in the business. He
is entitled also to a profit which while not exorbitant
should yet be such in amount that this and similar
enterprises will be encouraged and not discouraged.
The earnings required to meet interest and re-
placement apart from profit and operating expenses,
would be estimated as below shown, if the interest rate
to be allowed is 7 per cent and the steamboat which,
new, had an expectancy of 20 years is now estimated to
serve for 10 years longer:
For each $100 of original investment in the steam-
boat :
Interest on the rate-base 7 per cent on $100 $7.00
Replacement requirement, computed from probable life,
7 per cent 2.44
Total $9.44
To the allowances thus computed on the entire in-
vestment there are to be added the ordinary operating
expenses and also profit.
If the practice of deducting accrued depreciation
from the value of physical properties be followed the
computation would be as follows (again without in-
clusion of the operating expenses and the profit allow-
ance) :
Original investment $100.00
Accrued depreciation when the remaining life of
the steamboat is 10 years, interest 7 per cent. 33.70
Rate-base (so-called present value $ 66.30
Interest on the rate-base (present value of each $100
of original investment) 7 per cent on $66.30 $ 4.64
Replacement requirement, being the amount to be earned
annually to retire the so-called present value in the
remaining years of the steamboat's life, ($66.30 in
ten years, 7 per cent interest) 4.80
Total $ 9.44
In the one method of procedure a rate-base is used
which may depart widely from the value of the steam-
boat, in the other method the depreciated value of the
steamboat is introduced and this is made the rate-base.
In practice, however, to care for the profit element
it has become customary to add to the present value
of physical properties the value of certain intangible
elements, so that in the great majority of utilities,
GENERAL COMMENTS 5
made up of many items, the present value as used may
be raised to or even beyond the natural rate-base de-
termined from legitimate original investment un-
diminished by depreciation.
The aggregate value thus approximated may be a
more or less arbitrary amount on which the rate of
return is to be interest plus profit, or it may be the
actual value which it is planned should result from
a capitalization of net earnings at the interest rate
at which money is obtainable for the type of utility
under consideration, due regard being had to neces-
sary discounts and commissions. If this interest rate
is 7 per cent there would in the first case, a rate of
return be allowed of perhaps 8 per cent or 9 per cent,
of which 1 per cent or 2 per cent, as the case may be,
would represent a profit in addition to the interest on
that part of the intangible values known as "going
value." In the second case the "going value" would
be represented by the owners capitalized profit and the
allowed rate of return would be not less than 7 per
cent though possibly no more. Conversely, in this case,
the interest on the intangible element "going value"
would be the profit allowance.
Legitimate Earnings
The earnings of every public utility should be
adequate
(a) To yield a proper interest return on the cap-
ital which has been legitimately invested in the enter-
prise ;
(b) To renew essential items of the property when
for any reason the items which have been in use
must be abandoned;
(c) To meet operating expenses, including taxes,
overhead, and all repair and maintenance require-
ments ;
(d) To yield a profit, as compensation to the
owner for management and hazards, and as a share in
general prosperity ;
(e) In exceptional cases to retire the invested cap-
ital in whole or in part when the life of the utility
is limited;
6 PUBLIC UTILITY RATE FIXING
(f) To amortize early losses or other legitimate
sacrifices made by the owner and not proper for in-
clusion in the rate-base.
The legitimate original investment is not meas-
ured by original cost. This cost is to be taken into
account, but, according to circumstances, remains sub-
ject to correction. The term investment as here used
is understood to include actual cost of franchises and
water-rights and strategic values of the same but not
the intangible element of going value. The latter, as
above stated, is the result of the profits of the business.
Under certain circumstances the cost of reproduction,
including an allowance for the cost of developing the
business, will be the best guide in determining the
legitimate investment, therefore, the natural rate-base.
The Knoxville Waterworks Case with Reference to
Past History of Public Utilities
The writer is not in accord with those who accept
the principle laid down in the Knoxville Waterworks
case by the Supreme Court of the United States, 3
to the effect that past earnings should be assumed to
have been adequate, when it says:
"A water plant, with all its additions, begins to depre-
ciate in value from the moment of its use. Before coming
to the question of profit at all the company is entitled to
earn a sufficient sum annually to provide not only for current
repairs, but for making good the depreciation and replacing
the parts of the property when they come to the end of
their life. The company is not bound to see its property
gradually waste, without making provision out of earnings
for its replacement. It is entitled to see that from earn-
ings the value of the property invested is kept unimpaired,
so that, at the end of any given term of years the original
investment remains as it was at the beginning. It is not
only the right of the company to make such a provision,
but it is its duty to its bond and stock holders, and, in the
case of a public service corporation, at least, its plain duty
to the public. If a different course were pursued, the only
method of providing for replacement of property which has
ceased to be useful would be the investment of new capital
and the issue of new bonds or stocks. This course would
212 U. S. Reports 1; 29 Sup. Ct. Rep. 148.
GENERAL COMMENTS 7
lead to a constantly increasing variance between present
value and bond and stock capitalization a tendency which
would inevitably lead to disaster either to the stockholders
or to the public, or both. If, however, a company fails to
perform this plain duty and to exact sufficient returns to
keep the investment unimpaired, whether this is the result
of unwarranted dividends upon over issues of securities, or
of omission to exact proper prices for the output, the fault
is its own. When, therefore, a public regulation of its prices
comes under question, the true value of the property then
employed for the purpose of earning a return cannot be
enhanced by a consideration of the errors of management
which have been committed in the past."
According to the view here expressed by the court
every public utility should at once upon the begin-
ning of operation earn enough, not alone to recover
interest on its investment, but also to retire the va-
rious articles in use, each within its term of useful-
ness. This is manifestly impossible because in the
great majority of cases the rate-payers will be few at
the beginning of operation and it would be imprac-
ticable to exact from them rates that would produce
earnings determined by such a requirement. There
will be lean years, years during which additional sac-
rifice will be demanded from the owner. Such sacri-
fice he must make to establish his business on a pay-
ing basis. Consideration must be given to this situa-
tion and, in determining the legitimate investment,
it is proper to include therein a fair amount for the
cost of developing business.
To ignore past history of the utility and to assume
that if the owner has not exacted an adequate return
it is his own fault, appears to the writer unfair.
In connection with the decision of the U. S. Su-
preme Court in the Knoxville Water Co. case the
writer makes the following comment in his book on
"Valuation," 4 p. 135:
"Past history cannot be ignored if rates are to be so
fixed as to be fair alike to the owner and to the rate-payer.
In other words, not all shortage of earnings in the past is,
to be ascribed to errors of management. It is difficult to re-
*"Valuatlon, Depreciation and the Rate-Base."
8 PUBLIC UTILITY RATE FIXING
concile the language of the court with this principle even as
it is difficult to understand why so many of the courts have
held that value which results from earnings must be made
the starting point when rates are to be fixed."
Sometimes, of course, the situation is presented
of past earnings that were beyond all reason. The
principle of "all the traffic will bear" may have been
misapplied by the owner and it may be that not only
what should have gone into a replacement fund, but
more was actually collected from the rate-payers and
that this excess as well as what should be in a re-
placement fund, was distributed as dividends, there-
by leaving the property in an impaired condition. It
is not to be understood from this statement, how-
ever, that profits, that is, earnings in excess of an
allowable interest return, are in all cases to be con-
strued as having been available for the retirement of
capital or as a replacement fund. Even when there is
some profit the utility might still fall short of ful-
filling expectations, because both the original owner,
and his successors, were and are entitled to more
than a bare interest return on the sacrifice which they
have made in establishing and maintaining the utility.
In the case of the complex long established cor-
poration-owned utility, which is about to be brought
under review for the purpose of having its rates reg-
ulated, the presumption should be that fair or even
large profits in the past were legitimate and that
having been absorbed in the dividend distributions
to former stockholders, it would be unwise, as well
as unfair to the present stockholders, to make the as-
sumption that a part of these past earnings, usually
taken as equal to the accrued depreciation, should all
at once be deducted from original investment when
setting a limit to the value which the earnings will be
allowed to create. The unfairness or injustice of such a
procedure has been generally recognized with the result
that the allowance in the rate-base for intangible ele-
ments, particularly for "going value" is contended for
by most valuation experts and is generally allowed,
although none but arbitrary methods of determining
the amount thereof have as yet been suggested.
GENERAL COMMENTS 9
Ordinary Assumption that Capital Has Been Retired
Not Justified
Ordinarily, therefore a procedure should be
adopted based on the assumption that a utility, of the
complex permanent character, has not retired any
capital. Its earnings have been used to make repairs
and replacements of abandoned property, keeping the
utility at 100% efficiency, also, to pay interest and
profit to the owners. The utility should be assumed to
have been conducted exactly as would be expected if it
had perpetual life. Some such assumption must be made
as an aid in determining the treatment to which the
utility is entitled when its rates are fixed for the future.
If depreciated value of physical elements is made the
starting point this could only be predicated on the as-
sumption that to the extent of the accrued depreciation,
capital has been retired out of earnings. But such an
assumption is just, only in cases where the fact is ob-
vious. Otherwise the proceeding should be to intro-
duce into the calculation, a rate-base representing
legitimate original investment, as already defined, un-
diminished by depreciation, and to allow in the earn-
ings such a replacement increment as will make ade-
quate provision for the renewal or replacement of
each item of property as the same becomes useless
and is abandoned.
Adequate Earnings Include Profit
But when a rate-base is thus determined and an
interest return is applied to the same which will prop-
erly compensate the owner for the use of his money
(due allowance being made for discounts and com-
missions) some provision must be made to give him,
in addition thereto, compensation for management, and
for hazards, and also to give him a share in the general
prosperity of the community, because this prosperity
must in part, be ascribed to the installation and opera-
tion of the utility. This reward, as already intimated,
usuaally, though awkwardly, makes its appearance in
the allowance for ''going value" and in the appreciation
of real estate and other properties where value in-
creases with age, and also in a rate of return so fixed
10 PUBLIC UTILITY RATE FIXING
that it will exceed in some measure a bare interest
return. By this addition to the interest rate the at-
tempt is made to bring profit into some relation to the
value of the utility. This does not work well pe-
cause one utility may be of a type requiring a large
investment to secure a given amount of revenue,
while another may secure the same revenue on a
trifling investment. There is, in other words, some-
thing else to be brought into the calculation besides
a rate-base. The writer in"Valuation, Depreciation and
the Rate-Base," p. 160 says :
"While it is important to establish a rate-base whenever
rates are to be fixed, there may be cases in which other cir-
cumstances are of equal moment with the rate-base as a
guide to the allowable earnings. It may happen that the
public service requires only a small investment of capital
compared with the volume of the business that is transacted,
and it may then be more desirable and equitable to bring
the compensation of the owner into some relation to the
volume of business transacted rather than to the capital
which is invested in the business.
"The case may readily be conceived of a concern such
as an express company which rents its office facilities and
operates under contract with railroad and steamship com-
panies and which, outside of its trucks and other vehicles
for the local distribution of the parcels entrusted to its care,
has made no investment of any moment. It would be vain
in such a case to attempt a regulation of rates based solely
upon a fair return upon the invested capital. The whole field
must be brought into view. The volume of business trans-
acted, and the value that would be created if earnings are
allowed which exceed, in some definite fashion, the cost of
conducting the business, should receive due consideration.
If earnings are thus allowed which exceed the cost of opera-
tion by 10 to 15 per cent, this would not seem unreason-
able unless the resulting rates are, in fact, more than the
traffic can or should bear."
Gross Annual Income as Basis for Profit
Allowance
It need only be added that such a profit allowance
as here suggested might well be graduated accord-
ing to the gross annual income, making the allow-
ance larger, perhaps 15 per cent for the smaller con-
GENERAL COMNENTS 11
cern and dropping materially below 10 per cent when
earnings of $10,000,000 to $100,000,000 per annum and
more are under consideration.
There will, however, be special cases when even
such profit allowances as here suggested will be, at
least temporarily, inadequate. Let it be supposed for
example that the owner of the utility has made an
invention or can secure the right to use an invention,
by the introduction of which he can materially reduce
the cost of operation, but that the introduction of
the invention involves the abandonment of property
which would, except for the innovation, have remained
long in service. Under any hard and fast rule that no
property value shall be included in the rate-base ex-
cept it be in use, there would be a sacrifice by the
owner represented by the former value of the discarded
property. Furthermore, cost of operation being taken
into account and this cost being reduced, there would
be good ground for a corresponding reduction of rates.
If such a reduction be made to the full extent of the
reduction in operating expenses, the entire benefit of
the invention would go to the rate-payer and the owner
might find himself penalized to the extent of the value
of the abandoned property. The proper proceeding
in such a case is to allow to the owner the benefit
resulting from the reduction of operating cost, for
a certain time, long enough at least, to let the benefit
amortize or retire the investment in so much of the
property as is rendered useless, the owner finds it to
his advantage to lower his prices for the purpose of
increasing his business and thereby augmenting his
net earnings, and thereafter, to divide the benefit be-
tween the owner and the rate-payer on a mutually
advantageous basis, which will be done by introducing
a larger profit allowance into the calculation than
would be there under ordinary circumstance, and yet
not so large as to deprive the rate-payer of some
share in the benefit which has resulted from the use of
the invention.
12 PUBLIC UTILITY RATE FIXING
The Replacement Requirement
There is yet another question that arises whenever
the amount of allowable earnings is to be determined
for a public utility. This relates to the allowance
which should be made for replacement or renewal re-
quirements, or, as some valuation experts would
say, for "current depreciation." If the property is all
new and if conditions are such that any earnings de-
termined to be reasonable and proper will actually ma-
terialize in the income from the beginning of oper-
ation, then it will be proper to proceed according to
sinking fund methods using the same rate of interest
as is applied to the rate-base. The replacement incre-
ments must then be placed in a fund, or will at least
appear on the books to be in a fund, and the earnings
of this fund must be held inviolable for use in sup-
plementing the annual replacement increments. The
fund's earnings, plus these increments, if assumptions
as to probable life of the items of the plant have been
correct, will be just sufficient to make renewals as
these may be required.
As an alternative to this method of procedure the
practice may be followed, a new plant being again
under consideration of allowing the actual replace-
ment requirements from year to year, nothing the
first year, a small amount the second year and increas-
ing amounts thereafter until a time is reached when
the replacement requirements will be approximately
those estimated by the straight line method. This
method has the advantage of simplicity. It is the
method adopted on public works, such as streets
sewers, public buildings, harbors and generally all
public non-revenue producing properties. It is the
common sense method.
Under neither of these methods, if properly ap-
plied, and if the replacement fund is actually created in
proper amount out of earnings, will there have been
any retirement of capital. The rate-base in each case
will be original investment undiminished by accrued
depreciation.
GENERAL COMMENTS 13
When the utility to be brought under regulation
is no longer new ; when it represents a plant which
has seen long service, but which is at full efficiency
when gauged by its own standard and falls into that
class for which it should be assumed that past earn-
ings have not retired any of the investment, the first
inquiry will be as to whether or not there has been
established out of earnings any replacements fund. If
there be none, then the actual current replacement re-
quirement will be the proper allowance. This will have
to be estimated perhaps by the straight line method,
corrected by practical experience. If the estimate be
at fault no harm will be done as there will be a sepa-
rate accounting for the money which goes into the
fund and if the same is either depleted or grows too
fast, suitable correction can readily be made in the
future replacement allowances. When there is a fund,
the earnings of which are retained therein, then the
fund earnings will reduce the replaceement increment
which is to be collected from the rate-payer.
Accrued Depreciation Non-Essential in Rate
Fixing
It will be seen from the foregoing that the vast
amount of work which has been clone in recent years
to ascertain accrued depreciation as an element for
consideration in regulating the rates of railroads and
other public utilities is wasted energy. The require-
ment apparently laid down by the courts that value
must be made a starting point has led experts and
valuation commissions to seek new meanings in the
world value. The writer hopes that some day the
supreme court will so interpret or modify its Knox-
ville decision that the public service commission will
feel free to cut loose from value when fixing upon
a rate-base. He has faith in the valuation experts and
economists but believes that they should press with
greater vigor the demand for a simplified procedure.
It is their duty to enlighten the courts. They should
have the courage to point out any correct proceeding
even though in conflict, at least apparently so. with
the decisions of the courts, because anv conclusion of
14 PUBLIC UTILITY RATE FIXING
the (court as expressed Sn ithe Knoocville decision
remains binding only until the same has been modi-
fied by a later finding of the same high authority.
Until this is done, however, the valuation engineer
will find it advisable to comply with the requirements
of the public service commissions, and to struggle
with "present" and "market value" and let the commis-
sions and the courts make the most of a bad sit-
uation. Now and then he may find a court which is
bold enough to say that accrued depreciation may be
ignored as in Idaho where, in the Pocatello Water
Company case the Supreme Court of the state re-
cently, said':
"So far as the question of depreciation is concerned, we
thinlT'deduction should be made only for actual tangible de-
preciation and not for theoretical depreciation, sometimes
called 'accrued depreciation.' In other words, if it be demon-
strated that the plant is in good operating condition and giv-
ing as good service as a new plant, then the question of
depreciation may be entirely disregarded."
The Bonus and the Rate Base
The question is sometimes asked, "How does a
bonus affect the rate-base?" The answer to this ques-
tion should be given with due regard to all circum-
stances. Thus for example, if the owner is given a
bonus to build a steamboat equal to the entire cost of
the steamboat and the earnings are such that within
the life of the boat there will be a surplus, above op-
erating cost plus compensation to the owner for man-
agement, such that this surplus will build a new steam-
boat, the owner will have at no time made any invest-
ment and it may be proper to use a rate-base without
inclusion of the steamboat. If, however, the earnings
have yielded only a moderate excess over operating ex-
penses and no fund has been, nor could have been
created out of surplus earnings from which to pay for
the renewal of the steamboat, then the new steamboat
will have to be constructed with funds borrowed or at
any rate contributed by the owner. The original bonus
will have disappeared as a business loss and the cost
of the new steamer will be included in the rate-base.
GENERAL COMMENTS 15
Or, as another illustration, in the interest of some local
project as, for example, the development of a coal mine
a line of railroad is built which is then turned over as
a gift, subject to the condition that it be operated, to
some larger railway system. The new owner of the
railroad in this case has made no investment. The coal
road may not pay. Perhaps its earnings will just off-
set operating expenses including a proper allowance
for replacement (depreciation). The new owner has
made no sacrifice to acquire the coal road. Its cost
need not be included in the rate-base unless the ad-
dition of the road as a profit allowance is justified by
circumstances. In most cases in practice the latter
will be proper and ordinarily when long established
systems and long past transactions are under review
no other course would be allowed. The situation is
similar when a tract of land is laid out in town lots
and the streets are improved and water and gas mains
are laid and these mains are then donated to the
established water and gas companies with no condi-
tion other than that water and gas be supplied to
those who locate upon the tract. Here again the own-
ers of the water and gas works enter into obligations
to operate and maintain the additions to their systems,
but they have made no sacrifice to secure these addi-
tions which in the end will be paid for by the pur-
chasers of the lots in the subdivided area. Conse-
quently these additions should not appear in the rate-
base, at least not at full cost until the demand upon
them is so large that their inclusion will not be a bur-
den upon the rest of the system. "Whenever included,
unless they have been operated at a loss (receipts
less than operating expenses), their inclusion will be
equivalent to a profit allowance to their owners. Good
practice would be to give preference to the inclusion
of such donations except when they are of recent date
or when other circumstancs warrant a special investi-
gation to determine the course of action.
16 PUBLIC UTILITY RATE FIXING
Cost and Value of Water Rights in Their Relation
the Rate Base
That a water-right has value is now a generally
recognized fact. When water is used for irrigation it
assists in producing a crop which can be put on the
market at prices not subject to regulation. The water
delivered at the irrigated farm has a value deter-
minable from the profit which it enables the farmer
to make by increasing the crop output of his soil. The
water in the stream from which the canal system ob-
tains its water for delivery to the farmer, has greater
or less value according to many modifying factors such
as the character and value of the crop irrigated ; the
amount of water required to produce the crop ; the cost
of the canal system in relation to the acreage served;
the quality of the water ; the availability of alternative
sources of supply ; the limit of the supply in the avail-
able sources in comparison with the area of irrigable
lands ; the cost of preparing the land for irrigation ;
and the prospective demand upon the source of supply
for higher uses of the water. The riparian right, too,
has value not alone because the water is in the stream
at the border of the land but also because under the
doctrine of riparian rights the land owner has a lim-
ited right to use the water. Consequently when there
is any new development involving the utilization of
water the adjustment with the owners of prior rights
may involve an outlay. In any well settled region,
the cases will be rare in which water can be had with-
out cost. Any legitimate expenditure for water rights
by the owner of a public utility is to be made a part
of the rate-base. Whenever, therefore, the time has
come when the use of the water is a necessity and there
is no cheaper alternative source of supply, a strategic
value may result as in the case of rates which were
determined by the less favorable situation of some
other concern operating in the same territory. On this
subject the following is taken from "Valuation, Depre-
ciation and the Rate-Base," page 216:
"As an illustration of special water-right value the case
of a water supply for general and domestic use which affords
GENERAL COMMENTS 17
water of prime quality in limited amount may be taken, but
which, when compared with other sources in use in the same
community, has the advantage of proximity, elevation and
reliability of service.
"Let it be assumed for example, that such a supply
was the first to come into use, that its water was distrib-
uted as required throughout the built-up section of a growing
town, but that at length a time came when additional water
had to be brought in by a second system from some remote
source, and that at the time of the valuation the distrib-
uting pipes of each of the two systems cover practically the
entire built-up territory. The original water-works may now
be supplying only a small fraction of the aggregate amount
of water being used. Undoubtedly under such circumstances,
the charge for water by the two concerns would be the same
or very nearly the same. The water from the newer works
could not be supplied at a low enough rate to drive the
earlier concern out of business. Without any reduction of
rates, this original utility should hold its customers. There
need be no falling off in the amount of water which it sup-
plies, assumed to be the limit of its capacity. But, if, as
assumed, the rates charged by the two concerns are the same,
the relative amount of net earnings will be greater for the
original than for the new water-works. If it costs the orig-
inal concern 17.5 cents per thousand gallons to develop and
market its water crop (interest on the investment included)
and it is costing the new concern 20 cents to do the same,
and if this larger cost has been taken into account in fixing
the water rates, then the water-right and other intangible
elements of value of the original concern may reasonably be
valued at ($200-$175) $25, per day per million gallons of
daily delivery more than the water-right, and other intangi-
ble elements of value of the new concern. This is interest on
about $150,000, if 6 per cent per annum be made the basis
of the calculation.
"If, in other words, rates are allowed which in the case
of the new or main water-works system will create a water-
right value of $50,000 per million gallons of daily delivery
for the new water-works, then the value of the water-rights
controlled by the original system may be about $200,000 per
million gallons per day."
How to determine the value of a water-right is a
question which has not yet been satisfactorily an-
swered. There is no general market for water-rights.
18 PUBLIC UTILITY RATE FIXING
Their beneficial use is restricted to limited areas and
to certain purposes such as the generation of power,
irrigation and domestic use. It is not possible to go
into the market at any time and to secure a bid for a
water-right. Nevertheless there are cases in which
a determination, at least of an upper or lower limit of
value, can be made. The city of Sacramento, for ex-
ample, draws its water direct from Sacramento River.
The low water flow of the river at Sacramento is about
5000 cubic feet per second. The demand of the city
upon the river in comparison with this volume is so
small as to be almost negligible. The abstraction of
the city water is no damage to navigation interests nor
to the rights of riparian owners. The state has not
exacted any payment for the privilege of taking the
water. The water-right has only nominal value
although the water is applied to the highest possible
type of use.
In contrast with such a situation, there is the
water power right controlled by riparian ownership in
a region where the demand for power is such that the
desirability of utilizing the water power is unques-
tioned. The value of the power right in such circum-
stances is determinable from the market value of
power as established by the use of oil or coal, as the
case may be, provided always that the water power
is not of such magnitude as to completely crowd coal
and oil out of the field. In the event that this happens
the steam plant can do no more than determine an
upper limit of the value of the water-power.
Conditions may be such that at current prices of
fuel the cost of developing power is less with steam
than with water in which event the wisdom of the
water power development may be called in question.
But in view of the advantage to society of bringing
all water powers into use so as to conserve the con-
sumption of the oil and coal, whose supply is limited,
the case will be rare in which the owner should
be denied a reward for having gone into the power
business as he might be in case that no profit is
allowed, the absence of which would eliminate all in-
GENERAL COMMENTS 19
tangible values, including the water right. When such
a case is presented liberal treatment may be expected
and even demanded as a reward for the conservation
of power that otherwise would be lost. The owner,
even in such cases, is entitled to share in the benefit
which he confers upon society.
Appreciation in Relation to the Rate Base
Shall appreciation be allowed to the public utility
and if so, how? Yes, but within limits. If instead of
owning the properties whose value increases with age,
such as real estate, these properties were leased from
outside owners, the demand by such outside owners
would be for rentals increasing with the increasing
value. The increasing value may, therefore, be allowed,
but if allowed it is a part of the aggregate profit which
should go to the owner as already explained, to permit
him to participate in the general prosperity of the
community, which is reflected in the appreciation, and
to compensate him for management and business haz-
ards. As the appreciation of real estate is not reg-
ular and cannot be forecast with any great degree of
precision, and as the appreciation in certain cases in
the past has been beyond any equitable allowance of
profit, it is more logical after regulation of rates has
commenced and a proper rate base has been once
established, to treat appreciating property as having
been dedicated to public use at its cost or, in some
cases, at the estimated cost of reproduction when the
initial valuation for rate regulation purposes is made,
always conditioned upon the payment by the public
of a reasonable amount for such use, and thereafter to
let the general profit allowance include something for
current appreciation, thus covering the owner's share
in the general prosperity and protecting the rate-
payer's participation in the utility's unearned incre-
ment. Under this system even the utility which does
not own real estate or other appreciating property
would also get a fair share of the unearned increment.
It should be remembered, in this connection, that the
value of money is constantly dropping. The rise in
20 PUBLIC UTILITY RATE FIXING
the value of real estate is, therefore, not entirely due
to the demand of society that it be used for higher pur-
poses. This rise is in part due to the fact that as time
goes on the same amount of money will purchase a
smaller amount of service or of the necessities and
conveniences that make life possible and worth while.
It is the function of the profit allowance to meet this
hazard among the others which would in part be cov-
ered by appreciation for the utility rich in real-estate,
but to which other utilities which own no realty are
also entitled. Herein will be seen good reason for
adopting the writer's suggestion of bringing the profit
allowance into a fair relation to the volume of business.
Illustrations Showing Practical Application of Some
Fundamental Principles
To illustrate some of the fundamental principles in
their practical application, a railroad property may be
brought under consideration which has been long in
operation. By an examination of book records and a
physical valuation it has been determined that the
legitimate original cost of the railroad may be taken at
$20,000,000 and that ordinary operating expenses are
$2,000,000 and the average annual expenditures for
replacements are $500,000 per year. In making an ap-
praisal of value in conformity with the requirements
of the Interstate Commerce Commission, it is found
that the accrued depreciation of physical properties is
$4,000,000. The appreciation in this case and the cost
of developing the business are assumed to be in-
cluded, so far as allowable, in the $20,000,000. The
bonds of the road are 6 per cent and a fair allowance
for discounts and commissions shows that 7 per cent
would be a fair net rate of interest on borrowed money
free from any profit increment.
Under the proceedings as they are customary the
further inquiry would relate to the "going value" and
to the proper rate of return on the fair value of the
property. Suppose the going value is allowed at
$2,000,000 and that 8 per cent be agreed upon as a
fair rate of return.
GENERAL COMMENTS 21
According to the usual custom the allowable earn-
ings would be found as follows:
Coat new - $20,000.000
Accrued depreciation 4,000,000
Cost new legs depreciation $16,000,000
Going value 2,000,000
The present or fair value $18,000,000
Required Earnings
Operating expenses $2,000,000
Replacement allowance (depreciation) 600,000
Return allowance 8 per cent on $18,000,000 1,440,000
Required earnings ..._ $3,940,000
Besides this there will be some more or less
definite amount of appreciation which does not lend
itself to inclusion in such figures as these.
According to the alternative plan under which
accrued depreciation is ignored, as of no effect upon
the rates :
Rate-base, original investment $20,000,000
Required Earnings
Operating expenses ............... ._ ~ $2,000,000
Replacement allowance ~ 500,000
Interest 7 per cent on $20,000,000 1,400,000
Profit allowance 10 per cent of the annual income about 400,000
$4,300,000
Either there must be considerable property in the
possession of and in use by the railroad company of
the type, which is increasing in value ; or, under the
first procedure, the allowed rate of return, 8 per cent,
is too small ; or, the allowance for going value is too
small. If the last suggestion were the correct one and
not supplemented by other factors, then "going value"
should be increased to about $7,000,000 instead of the
$2,000,000 introduced into the calculation. If the cor-
rection is to be made in the rate of return this would
have to be allowed at about 10 per cent instead of at
8 per cent.
The advantage of bringing the profit allowance
into a fair relation to the volume of business is
best apparent in the case of a utility which does a
large amount of business on a small investment. Sup-
pose that an express company has invested $1,000,000
and that its gross annual income for several years,
has been about $4,000,000. If the accrued depreciation
22 PUBLIC UTILITY RATE FIXING
is $250,000 the ordinary procedure might be about as
follows :
Present fair value of physical elements, etc.
Estimated cost new $1,000,000
Accrued depreciation 250,000
Cost new less depreciation $ 750,000
Going value possibly 2,000,000
Fair value $2,750,000
Required Earnings
Operating expenses $3,400,000
Replacement allowance 100,000
Return allowance 17% on $2,750,000 480,000
Total $3,980,000
It will be noted that the reurn rate is introduced
into the calculation fairly high, because the invest-
ment is small and the courage is lacking to make the
intangibles appear in the rate-base at $5,000,000, or
more, as they probably would be rated by a purchaser
if the business is a monopoly.
Under the alternative plan the accrued deprecia-
tion would again be ignored and the profit allowance
would, perhaps, be about 10 per cent on the volume
of business:
Rate-base, the original investment $1,000,000
Required Earnings
Operating expenses $3,400,000
Replacement allowance 100,000
Interest 7 per cent on $1,000,000 70,000
Profit allowance 10 per cent on $4,000,000 400,000
Total $3,970,000
When all the capital is invested in a single depre-
ciating item, as in the case of a steamboat, as already
described the first step of the usual practice is to find
the steamboat's remaining value, a value which
changes from year to year. Suppose that the steam-
boat has cost $250,000; that it is found upon examina-
tion that it should serve about five years longer; that
a steamboat of its type has a probable life when new of
20 years, and that the amount of business (gross
income) has been about $500,000 per annum.
In this case the remaining value of the steamboat
would be determined by the sinking fund method and
for a remaining life of 5 years in a 20-year life table at
7 per cent would be found to be $97,000. Assuming
GENERAL COMMENTS 23
the steamboat business to be a monopoly there would
be something added for going value, perhaps as much
as a new steamboat would cost or $250,000.
The required earnings would be
Operating expenses - - $400,000
Replacement or depreciation allowance by the compound inter-
est method ; the amount which will retire the remaining
value in 6 years, 7 per cent interest 17,300
Return allowance 20 % on ($97,000 + $250,000) 69,400
Total - $486,700
While the question whether or not the earnings in
the past have actually been sufficient to yield inter-
est on the investment from the beginning plus the
increment supposed to have been applied from year
to year to retire capital will be a proper one, the large
allowance of intangible value covers any possible past
deficiency. This large allowance results from the
consideration, it is assumed, of all the circumstances
such as hazard, fluctuation in the annual volume of
business and the like.
Under the simpler alternative procedure the orig-
inal investment, $250,000 would be the rate base and
the required earnings would be estimated as follows :
Required Earnings
Operating expenses _ $400,000
Replacement allowance sinking fund method 20 year life 1% 6,100
Interest 7 per cent on $250,000 17,500
Profit allowance about 12 per cent of $500,000 60,000
Total $483,600
If water-works are under consideration the cir-
cumstances may be about as follows : The water-
works have been long in service. They were originally
built by a group of public spirited citizens and oper-
ated at a loss. This loss may or may not have been
a willing sacrifice offset by the growing value of
the real estate in the individual possession of the
owners. As the community grew, the water-works
grew. The original source of supply may have been
wells which had to be abandoned after a time because
contamination rendered the water unfit for domestic
use. Other near-by sources were brought into use,
some retained and others abandoned. The system, as
now in use, commands a supply of good water ade-
quate in quantity for some 20 years, with other sources
24 PUBLIC UTILITY RATE FIXING
in sight that can be developed at an increasing unit
cost. There has been no satisfactory regulation of
rates in the past. The original owners have passed
out of consideration and the stock of the corpora-
tion now owning the property is in the hands of many
people, some of whom have acquired it within the
last year or two. The bonds which are outstanding,
about $7,000,000 bear interest at 6 per cent and are
worth 95 per cent. There is no alternative supply
having advantages equal to the developed and pros-
pective sources. There has been no payment for fran-
chises. The acquisition of certain water-rights repre-
senting one-fourth of the supply has cost the company
$200,000. These water-rights were acquired 10 years
ago.
In this instance the books show the cost of construc-
tion during the recent years and the cost of the acqui-
sition of some of the lands and rights-of-way,- but
there is no information available relating to the actual
investment covering the entire period of operation nor
yet relating to whether the earnings fully amortized
the capital which had been invested in the property
abandoned from time to time. An investigation is
therefore made to verify and to supplement the records
of cost and it is found that, including the cost of rights-
of-way and the actual cost of water rights, whether
taken from records or approximated, the total actual
legitimate capital investment as of the date of the
proposed rate regulation is $10,000,000. In this ap-
praisal, market value of real estate is included when
its acquisition was not recent and does not appear
in the records. Cost and an allowance for the increase
of value may in many cases be a good guide in deter-
mining at what value it should be introduced as a
part of the invested capital. In this valuation of $10,-,
000,000 there are included all properties in use and
those held for use within a rather indefinite period
of some 20 to 25 years in the future.
If the value of physical elements and the value of
the intangibles must be taken into account, as the
courts and many of the rate regulating commissions
GENERAL COMMENTS 25
seem to require, it now becomes necessary to approxi-
mate the accrued depreciation of the physical elements.
This is done by approximating for each class of items
or for each item which is of sufficient importance to
be individualized, its remaining term of usefulness
or expectancy and from depreciation tables for the
probable life term new of each class and this life
expectancy, the accrued depreciation and the remaining
value are found. This tedious, difficult and unsatis-
factory proceeding shows for these water-works that
the accrued depreciation is $2,000,000.
Going value is now to be appraised. For this there
is absolutely no basis because it results from the in-
crement of earnings which is left after deducting oper-
ating expenses, current depreciation or, rather, re-
placement requirements, and interest on the invest-
ment. The best judgment of experts is called in, and
their chief aim will be to at least offset the accrued
depreciation. The result is an allowance of about
$2,500,000 for going value.
Now conies the question of water rights. One-
fourth of the water in use has actually cost $200,000
and this amount is included in the $10,000,000 of in-
vestment. If one-fourth of the water cost $200,000
and the remainder is equally valuable there should
appear in the "value," if itemized, an additional $600,-
000 for water rights and perhaps more, because the
basis of this calculation is a value which obtained
10 years ago.
The most common practice of the day would,
therefore, start with a valuation, being the present
or fair value as follows :
Physical elements and actual cost of rights-of-way
and of water rights, less accrued depreciation
$10,000,000 $2,000,000 $8,000,000
Water rights, value in addition to cost 600,000
Going value 2,500,000
Present value $11,100,000
It being assumed that this enterprise is in every
way legitimate and well managed, the value of the
outstanding bonds and their rate of interest can be
used as a guide to determine what the rate of return
should be on this valuation.
26 PUBLIC UTILITY RATE FIXING
At 95 per cent the 6 per cent bonds net 6.3 per
cent. The cost of marketing the bonds was probably
at least 1 per cent. It is likely, furthermore, that at
the time the bonds were issued the amount realized
was less than 95 per cent. It is concluded from such
facts as these that the cost of money for this enter-
prise should be taken at 7 per cent and that of the rate
of return on the value of the water-works should be 8
per cent.
Investigation has also been made of the cost of
operation and it is found that
Ordinary average annual operating cost including main-
tenance and repairs is $400,000
The average annual replacement requirement based on
actual experience is 200,000
The estimated current depreciation by sinking fund
methods which should have been earned from the
beginning is found to be 64,000
In determining the required earnings what allow-
ance shall be made for current depreciation? This
must be settled by those using this procedure with
due consideration to the facts in each case. There
is no depreciation or replacement fund in this case,
consequently there is no interest on such a fund to
supplement the estimated current depreciation. The
earnings must cover the annual replacement require-
ments which are best determined by actual experi-
ence but which can also be approximated by well
known methods of procedure. Using the result of
actual experience in this case the required earnings
are now estimated as follows :
Required Earnings
Operating expenses I 400,000
Replacement or depreciation allowance ordinarily esti-
mated but in this case determinable from actual
experience at 200,000
Return allowance S per cent on $11,100,000 888,000
$1,488,000
The application of the simple alternative pro-
cedure in this case is as follows :
The rate-base is the legitimate investment, $10,000,000.
Required Earnings
Operating expensf-s $ 400,000
Interest 1 per cent on $10,000,000 700.000
Replacement requirement 200,000
Profit allowance 12 per cent of $1,500,000 (approx.
gross income) 180,000
$1,480,000
GENERAL COMMENTS 27
Investment as a Rate Base Contrasted with Value
The one procedure is logical throughout. The
other is not. In the alternative the going value and
the water-right value are fully covered in the capi-
talized profit allowance. In connection with the rate-
fixing proceeding there is no need of separating these
intangibles nor even of inquiring whether if aban-
doned by the utility the water right might not have
a higher value than a fair division of the profit allow-
ance would give it. The full protection of the invest-
ment is secured and the rate-payer is given the sat-
isfaction of knowing that there is a limit set to the
profit which the owner of the utility may make in
the future. Once the basic valuation has been made,
as above set forth, the appreciation of real-estate and
other items would be covered in the profit allowance.
Additional appreciation would not again be carried into
the rate-base, but if appreciating property were at any
time in the future released from further public service,
its full value, including all appreciation, would go to
the owner at that time.
The valuations thus far required by all rate-fixing
authorities have been made with careful attention^
to the smallest details. A standard has been set for
the approximation of the cost of reproduction of the
plant, to be valued, which would be commendable,
except for the fact that the careful estimate of phys-
ical value is at once supplemented by the crudest kind
of an approximation of intangible values. No basis
has been established or found of determining the prin-
cipal intangible item "going value" and yet an arbi-
trary allowance for the same, always crudely approx-
imate and at times amounting to or even exceeding
the value of the physical elements, is added and given
rank and weight with the latter. The sooner such a
practice can be modified the better.
Interests of the Owner, the Rate Payer and
the Public
What the rate-payer has a right to expect may be
summarixed as follows:
2$ PUBLIC UTILITY RATE FIXING
(a) Good service, the best that conditions permit at
reasonable rates.
(b) A share in the unearned increment when general
prosperity gives this to the owner of the utility in
too large a measure.
(c) A reasonable share, in the course of time, in the
benefit which results from any material reduction
in operating costs due to the introduction of in-
ventions or new processes which the owner's good
management and skill have shown to be advan-
tageous.
(d) A contribution by the general public toward the
maintenance of the utility, which may be secured
by a liberal payment for service rendered for com-
modities furnished to the public or to public insti-
tutions or which may be secured by a remission
of local taxes in whole or in part :
What the owner should demand is :
(a) Interest on the capital legitimately invested.
(b) An ample allowance for replacements and re-
newals.
(c) An ample allowance for operating expenses.
(d) Amortization of capital invested in abandoned
property.
(e) Compensation for management and for assuming
business hazards.
(f) A share in the general prosperity which his utility
helps to create.
(g) In the special case of a limited life of the utility
or its acquisition by the public, a return of the
invested capital.
(h) That amortization of the invested capital be not
confounded with accrued depreciation.
What both the rate-payer and the owner are en-
titled to in addition to the above and what both should
demand is :
The introduction of a method of procedure
when rates are to be regulated which will not re-
quire an array of valuation experts, to pad a close
estimate of physical values with a number of ar-
GENERAL COMMENTS 29
bitrary intangible values, but which on its face
will be intelligible and fair to all concerned.
The items (e) and (f) as enumerated under the
owner's demands can best be met as already explained
by making an adequate minimum profit allowance
based on the annual gross income.
If the rate-payers are few and a reasonable service
rate will not fully compensate the owner, then he
should be held harmless in the future larger returns.
In the case of the business which has been oper-
ating without regulation and which is to be brought
under regulation, the present owners should not be
made to suffer unnecessarily for the mistakes and im-
proper business methods of their predecessors.
Once the determination of the natural rate-base
has been made, the future modifications thereof should
be from the book records which should be such as to
show at all times the additional capital legitimately in-
vested, the discarded property and its cost, and the
condition of the replacement fund, which altter should
be just adequate to meet the regular demands upon it
for replacements or renewals, and, if desired, also the
repairs and generally unkeep expenditures.
The bringing of accrued depreciation into the
calculation as though it represented amortization ol
a part of the investment is absurd ; it leads to a com-
plex, unsatisfactory procedure, and compels the use
of arbitrary allowances for intangible values which
should have no place in a rate-base. All methods of
procedure which take account of the accrued deprecia-
tion when rates are to be regulated should be definitely
and finally proscribed, and eliminated from considera-
tion.
Difficulty of Ascertaining Depreciation
In December, 1916, a special committee of the
American Society of Civil Engineers rendered a report
on the Valuation of Public Utilities in which they
accepted the apparent requirement of the courts, that
value be ascertained and made the starting point when
rates are to be fixed. The committee strongly advo-
cates the use of a method of procedure which it calls
30 PUBLIC UTILITY RATE FIXING
the compound interest method in distinction, from
what to many others has appeared as the more log-
ical, the sinking fund method. Under the compound
interest method the value, of the physical elements
is to be ascertained from time to time, perhaps from
year to year, by deducting accrued depreciation, and
the allowance for current depreciation of each indi-
vidualized article is .to be a gradually increasing
amount, readily computed from original cost, probable
life new and age. The committee overlooked some
of the difficulties of applying this method to one of
which attention may be briefly called. This is apart
from the fact that the compound interest method like
any other method which pretends to start with value
in any form, is illogical and should be condemned.
The committee explains how the current depreciation,
which they should have called amortization of capital,
can be computed or can be taken from tables for any
year of the life of an article whose probable life new
is known. But the committee fails to point out how
to proceed when of a large number of articles, such
as locomotives, some fail before their predicted term
of usefulness has expired and others survive long
beyond this term. Neither the sinking fund method
nor the compound interest method takes this non-
agreemcnt into account. A mathematical solution
has not been attempted by the advocates of these
methods. None is possible, as a matter of fact, until
the expectancies at various ages for the various arti-
cles under consideration shall have been determined
with some degree of accuracy. The probable life is
merely the average of all available records of service.
It is the result of the recorded human experience
with all articles of any class. While this probable
life new may be predicted with some degree of con-
fidence for many articles, the individual articles of
any class will depart widely from the term of life
predicted for them as a class. The probable life being
a mean of the actual terms of service of numerous ar-
ticles, there will be among these articles for each one
which fails m years before the expiration of its prob-
GENERAL COMMENTS 31
able term, another which survives m years beyond this
m
term, or two which survive years beyond the term,
2
m
or three which survive years beyond the term, and
3
so on.
Suppose that a large number of locomotives of a
certain type are under consideration, whose probable
life new has been correctly estimated at 20 years.
For each locomotive which fails and is discarded 10
years before the end of the 20th year after it went
into service is reached, there will be one surviving
to the end of the 30th year or two surviving to the
end of the 25th year or three whose average service
beyond the predicted period is 3.33 years and so on.
Introducing 7 per cent into the calculation and
following the ordinary erroneous practice, the depre-
ciation (or replacement) allowance for the first year
would be in percentage of cost for four locomotives :
Replacement requirement, ordinary allowance (current
depreciation) 1st year 4 X 2 - 44 H- 4 = 2.44%
Compare this with the following illustration of
what is bound to take place, though perhaps not at
exactly the assumed terms of actual life of the indi-
vidual locomotives :
If two locomotives fail at 10 years and the other
two at 30 years, the allowance for replacement
by the sinking fund or compound interest
methods of computation which are here under
discussion would be:
2 failing- at 10 years. 2 X 7.24 =: 14.48%
2 failing at 30 years. 2 X 1.06= 2.12
Total, required allowance 16.60 -f- 4 = 4.15%
If o'ne locomotive fails at 5 years, one at 15 years,
and two at 30 years:
1 failing at 5 years 17.39%
1 failing at 15 years 3.98
2 failing at 30 years. 2 X 1.06 =r 2.12
Total, required allowance. ... 23.49 -=- 4 = 5.87%
If one fails at 5 years, two at 20 years and one
at 35 years:
1 falling at 5 years 17.39%
2 failing at 20 years. 2 X 2.44=: 4.88
1 failing at 35 years .72
Total, required allowance. ... 22.99 -f- 4 = 5.75%
32 PUBLIC UTILITY RATE FIXING
In each of the illustrative cases the average
actual life of the four locomotives will have conformed
to the predicted probable life of 20 years, but in each
case the allowance which should be made to amortize
the capital which goes out of use with the locomotives
is larger than that which is predicted on the broad, un-
warranted assumption that the probable life of locomo-
tives as a class may be made the basis of the calcula-
tion.
Stated generally the following is true :
Let r m , r n , etc., represent the replacement requirement
computed by Sinking Fund methods for an actual service of
n, m, etc., years as the case may be.
Let n represent the probable life in years.
Let m represent any number of years less than n.
Then
r T* "^ j* _- -
From which, r n _ m + r n + m > 2 r a
Similarly it can be shown that:
r n . m + 2 (r n + ) > 3 r n
2
and r D _ m + 3 (n, + ) > 4 r n
3
This means that the amortization or replacement
allowance for two or more articles having different
terms of usefulness should always be larger than the
allowances for the same articles if they be assumed to
fail altogether at the average of the individual terms.
The amortization or replacement if estimated from
the probable life new of any article will be too small.
In the practical application of this fact the valua-
tion engineer when called upon to determine how
much should be in a replacement fund or how
much capital should have been amortized out of the
ascertained earnings, will always find himself in trou-
ble. How he will get out of it depends upon the cir-
cumstances in each case.
There is some satisfaction in knowing that these
and other like difficulties can be avoided in the regu-
lation of rates, if the valuation authorities will have
the courage, as they have the right, to adopt some
method of procedure under which accrued depreciation
GENERAL COMMENTS 33
need not be estimated. The writer has intimated what
this procedure should be and he has fully described it
in the various publications already referred to. It
need only be stated here that he has named it, the Un-
limited Life method, that its correctness is unques-
tioned, that it does not involve any estimate of accrued
depreciation and that the current replacement require-
ment does not have to be ascertained with more than
a fair degree of approximation.
34 PUBLIC UTILITY RATE FIXING
CHAPTER II
ELEMENTS DESERVING SPECIAL CONSIDERA-
TION WHEN RATES ARE TO
BE FIXED
A OBSOLESCENCE
Obsolescence Cannot be Predicted
An appliance, machinery or a process of manufac-
ture in use by a public utility may under efficient manage-
ment at any time be superseded by a better device or
process. When this is the case more or less property is
usually discarded, which, under the conditions as they
prevailed when this property first came into use, should
have served for many years longer. Obsolescence has
forced its abandonment.
The knowledge that obsolescence may shorten the
term of usefulness of a machine or of portions of any
plant used in the public service has prompted valuation
experts and the rate regulating authorities to attempt
estimates of the allowances which should be made in the
earnings to cover the prospective abandonment of prop-
erty due to this cause.
The last word has not been said in the discovery of
new forces in nature and their adaptation to human
requirements. It is the belief of many engineers, for
example, that the internal combustion engine will put the
old types of marine engines of ocean freighters on the
scrap heap, and yet the older type under gradual develop-
ment to its present high state of efficiency has main-
tained itself for more than a hundred years.
The use of oil in place of coal, not alone as a pro-
ducer of gas but also as fuel in the production of steam,
has caused appliances and machinery to be abandoned
which would otherwise have continued in service. No
one today can be sure which of two extremes is most
likely to prove true, whether, for example, the last word
has been said in the manufacture of gas and there will
ELEMENTS DESERVING CONSIDERATION 35
be no further abandonment of standard gas making ap-
pliances and processes, or whether, due to exhaustion of
sources of oil, or due to other causes, there may not be
some new substitute for oil or for the gas itself found
which will render some of the most modern appliances
of the day obsolete in the near future.
Past experiences in the matter of abandonment of
property, due to obsolescence, is not a dependable guide
to what may happen in the future. In this respect there
is a difference between the failures from this cause and
those which result from the wear and tear of use and
from the somewhat less regular failures through acci-
dents incident to human frailty, fire and similar causes.
In the one case the basis for a satisfactory prediction is
lacking. In the other the probability of events occurring
in the future can be predicated with some confidence
upon what has occurred in the past. There is a differ-
ence, too, between replacements made as the result of
obsolescence and replacements due to failure from other
causes. In the case of obsolescence the replacement is
made with some device which betters the service the
output costs less, or the service is made more reliable or
,he quality of the output is improved, while in the case
of ordinary replacements or renewals the betterment of
service is not a necessary incident.
Treatment of Obsolescence and Replacement
Compared
It is proper to charge the rate-payer with the cost
of replacement when property fails from ordinary cause?
and to let the earnings, therefore, cover a replacement
increment during the useful life of any item of property
and to base the charge on the ordinary replacement re-
quirement as determined for such property. Not so,
however, in the case of obsolescence. This will be made
plain by the following considerations.
There would be no obsolescence if the improved
machinery or the new process which takes the place of
that which is being replaced did not result in some advan-
tage to some one. If the obsolete property were treated
a? though its failure had been correctly foreseen and as
36 PUBLIC UTILITY RATE FIXING
though funds for its replacement had already been col-
lected from the rate-payers and if the owner had not in
fact collected sufficient funds, and if thereupon the re-
maining value of the obsolete property or the capital
investment at which it was carried in the rate-base were
immediately ignored, and rates were established as though
the abandoned proper had never been in use, the rate-
payer would at once get the full benefit of the innovation
and the owner would have made a sacrifice of capital
which he could perhaps have avoided by being a less
efficient manager and holding to the older, less efficient
plan of operation. Let it be known that the usual pro-
cedure will be to forecast failures by obsolescence and
to amortize the capital in such properties on the basis
of assumed average conditions which means inadequate
amortization in many cases, and there will no longer be
any inducement to the owner to improve the efficiency
of his plant. He will conclude that it will be safest not
to use new inventions or to introduce new processes so
long as a sacrifice of capital is thereby involved. He
might, in making an innovation, find that he had on his
hands abandoned property, the cost of which has not only
not been fully returned to him but concerning the further
amortization of which the established rules of rate regu-
lating bodies may give no adequate assurance.
Obsolescence Should Affect Rates After, Not Before,
the Event
It seems self-evident that when the introduction of
a new invention, whether the same applies to a machine
or to a process, reduces the cost of operation, the result-
ing advantage should go to both the owner of the utility
and the rate-payer. But it is also true that in such event
there will be no hardship imposed on the rate-payer if
the benefit of reduced cost of producing the output, does
not come to him immediately. A reasonable procedure
would therefore be, in all such cases, to allow the rates
to remain as they would have been without the new
process, unless a reduction would result in increased de-
mand and greater net profit to the owner, at least long
enough to amortize so much of the original plant as is
ELEMENTS DESERVING CONSIDERATION 37
thereby rendered useless and, thereafter, to so adjust
rates that, for a suitable period of time, the benefit of
the reduced cost will be shared on a fair basis by the
owner and the rate-payer. Any treatment less favorable
to the owner of a public utility would discourage the
introduction of innovations if they involve further invest-
ment of capital and would make for inefficient rather
than for efficient management. The owner must not be
expected to consent to an increase of hazard without an
increase of profit.
The practice of attempting to foresee obsolescence
and of burdening the rate-payer before the failure by
obsolescence with the charge that is necessary to amortize
the capital which obsolescence renders useless, is not
alone unwise but unjust. It is not fair to the rate-payer
because those who pay rates before the betterment is
made should not be made to pay for the advantage which
will come to those who pay rates after the betterment
has been made ; it is not fair to the owner because while
apparently increasing his earnings it will act, as do all
high charges for service, as a deterrent upon the exten-
sion of business and because there will be cases where
by error in the estimate of time allowance for obsoles-
cence the owner will be called upon to make a sacrifice
when due to obsolescence property is abandoned, which
can not be offset against the advantage that may come
to the owners of other utilities who benefit by an allow-
ance for something which, in their case, never happens.
The obsolescence will, in many cases, occur before any
adequate provision has, in fact, been made.
Illustration
To illustrate the problem which is presented when
one type of machinery is replaced by a better type, let it
be assumed that the machinery of an old style generating
station has been replaced by steam turbo generators, that
the old machinery had been in use for some years, that
it was still in first class condition but that its abandon-
ment was advisable because, all factors being taken into
account, the generation of electric energy will be cheaper
with the new installation.
38 PUBLIC UTILITY RATE FIXING
Suppose that the remaining or present value of the
abandoned machinery, as a part of the utility, was $200,-
000 (original cost $250,000 less $50,000 earned replace-
ment), and that $75,000 was realized from its sale after
abandonment. Suppose further that an appraisal of the
new machinery after its installation shows that it should
be introduced into the rate-base at $150,000.
Two cases are possible, either the $50,000 of earned
replacement increments have actually been returned to
the owner and have reduced the remaining investment
from the original $250,000 to $200,000, or the $50,000
are carried in a replacement fund. In the first case on
the assumption that only property in use is carried in
the rate-base, there would be, after the new machinery
is installed, a value to be taken into account reduced by
the $200,000 and increased by the cost of the new ma-
chinery, that is, $150,000 less the sale value of the old,
or $150,000 $75,000 = $75,000. The result would be
a net reduction of present value, as appearing in the
rate-base, of $125,000. This amount, on some theory
other than "present value," could be retained in the rate-
base subject to amortization, or it could be transferred
to profit and loss or some other account where it would
be carried until together with interest thereon it is com-
pletely wiped out. In the seconl case the old machinery
would have been carried in the rate-base, at the time of
its obsolescence, at $250,000, the original cost, undimin-
ished by accrued depreciation, but this amount would
have been offset in part by the $50,000 in the replace-
ment fund. By the transfer of this sum the $250,000
would be reduced to $200,000 and there would then be
an addition of the net cost of the new machinery, or
$75,000. The rate-base would include on account of both
old and new machinery an amount of $275,000, which is
$125,000 in excess of what should be in it if original
investment in property in use is the determining factor.
In either event there will be $125,000 to be either carried
indefinitely in the rate-base or to be amortized within a
reasonable time.
Unless the owner felt reasonably certain that the
$125,000 would be returned to him in some way, he
ELEMENTS DESERVING CONSIDERATION 39
would not prematurely discard the old machinery. If as
a result of the change rates are reduced to a point ex-
cluding interest on and amortization of the $125,000 the
owner will have made a sacrifice for the benefit of the
rate-payer out of all reason. If, however, the rates re-
main undisturbed for a time, then, during this time the
excess of earnings, over operating expenses, will be
larger than it had been under the original plan of opera-
tion by the amount that the cost of operation has been
cut down. This increase of net earnings, perhaps cut
down somewhat by voluntary action of the owner, should
be used to amortize the $125,000 and interest thereon,
and when this is accomplished a reduction in rates would
naturally ensue, and the rate-payer would share in the
benefit resulting from the reduced cost of operation.
B LOSSES FROM FORTUITOUS EVENTS
Amortization of Losses from Fortuitous Events
Losses of magnitude which result from floods,
earthquakes, volcanic eruptions and the like and in
general, losses against which the owner can not in-
sure, belong to a class of sacrifices, which like those
due to obsolescence should be made good to the own-
er of the utility after the event, by the public, that
is to say, by the rate-payers. Such losses can not
be forecast. They should not fall entirely on the
owner of the utility. In some fashion and to a fair
extent, they should, in the course of time, be amor-
tized out of earnings. As a rule no provision for
other than ordinary risks is made in the allowed rate
of return. Consequently, after a catastrophe, for
which the owner is not responsible, but which entails
a large investment of new capital to rehabilitate a
public utility plant, there should be some provisions
for amortizing the loss. It will, in such event, be bet-
ter to let the amortization take place within a reason-
able time rather than to carry an equivalent sum in
the rate-base as though it were a permanent though
unproductive, interest-bearing investment.
40 PUBLIC UTILITY RATE FIXING
It will perhaps be claimed, by some, that such
losses should not be differentiated from the ordinary
losses due to unforeseen causes, and that whatever
hazard is involved in any enterprise has unqualifiedly
been assumed by the owner of the utility. Under such
a theory the allowance for hazard should at all times
be liberal enough to compensate the owner for the
chance which he takes of at some time suffering ma-
terial loss. He would be compelled to take the
gambler's chance and the rate-payer should stand the
higher rate. Under such a practice there would be an
owner here and there who would suffer large loss,
while the great majority of owners, escaping the
great catastrophes, would get what really should be
paid, in the exceptional case, to the unfortunate owner.
Under such a treatment of this matter, the tax for the
risk would fall upon those who are paying rates be-
fore a catastrophe occurs, as well as upon those who
receive service from the rehabilitated works. The
more logical procedure would be to relieve the rate-
payers from the burden of making the inadequate
provision for catastrophes which may never occur and
letting the loss that actually results from a catastro-
phe be met out of future earnings. The usual provi-
sion for meeting losses which result from such fortu-
itous events as are here under discussion, is inade-
quate. The owner does not, as in the case of losses
which must be made good by assurance companies,
get the full benefit of the allowance for risk which is
distributed in small measure or is at least supposed
to be distributed among all public utility owners and
is supposed to be collected in the earnings. The own-
er's share in this risk allowance is only a proportionate
one while the loss, when it occurs, can not be distrib-
uted to the other utilities of the country which escape
such loss, but falls in its entirety upon the one utility
that may be affected thereby.
In recognition of the fact that most utilities
escape such losses, the usual allowance in the public
utility rates for the element of risk is small and prob-
ELEMENTS DESERVING CONSIDERATION 41
ably in most cases negligible. The allowance for man-
agement, for business hazards, together with the al-
lowance for participation in the general prosperity of
the country, in short the profit allowance, would prob-
ably in few, if any cases, be materially reduced, if this
element of risk were entirely eliminated.
In all cases in which this interpretation of the
present day procedure is substantially true, it would
be unfair to an owner whose public utility plant sus-
tains material damage by flood, by earthquake or by
other fortuitous event, against which insurance is im-
possible, to let the entire loss fall upon him without
recourse. That such losses should in some way ulti-
mately fall upon those who are served by the utility
seems self-evident. The most equitable procedure
would be to let them be borne by the rate-payers
future. But as they can not be foreseen the practical
alternative would seem to be to let them fall in the
before the event as well as by the rate-payers of the
future as would be the case if the utility were publicly
and not privately owned.
In the case of a business not subject to regulation
the opportunity to make up for past losses exists if
larger profits can be made by charging what the traf-
fic will bear. Owners of public utilities should be al-
lowed to recoup their losses, if they can do so without
charging rates unreasonably high.
C HAZARD, MANAGEMENT AND THE
UNEARNED INCREMENT
The Allowance for Hazard, for the Unearned Incre-
ment and for Management Should Not be
Based on Value
All rate regulating authorities are devoting much
thought and study to the establishment of a proper
basis of calculation when the rates to be charged by
public utilities are to be fixed.
The highest court has said that value must be the
starting point and the attempt is therefore generally
42 PUBLIC UTILITY RATE FIXING
made to comply with this apparent requirement of the
court. The result is the use of a rate-base conforming
to "present value" or to something that may be called
present value, even though in making value the rate-
base it is occasionally found necessary to read new
meanings into the word value. After this value has
been ascertained in some fashion the owner of the
utility is allowed to earn a return thereon, usually
somewhat in excess of what would be a fair interest
return on money for investment in enterprises of like
character.
When there is included in the rate-base thus es-
tablished an allowance for "going value," the interest
return allowed and earned on this "going value," to-
gether with earnings to cover the excess of the return
rate over the ordinary interest rate, is the owner's
compensation for hazards and for management and
may also cover some participation in the prosperity
and increasing values of the property in the com-
munity which is served by the utility. If the allow-
ance for hazards has been correctly estimated, the
owner will in the long run get little or no advantage
therefrom, because this allowance will be offset
from time to time by losses or sacrifices of various
kinds. The allowance for participation in the general
prosperity is not always recognized as being due to
the owner for the reason that a part thereof, under
the prevailing system of using value as the basis of
the calculation, makes its appearance in the increase
of real estate values and in the increasing values re-
sulting from the gradual but recognized rise in the
price of materials and the rise in the wage scale. And
yet every utility helps to create the general prosperity.
It adds to the unearned increment of the vacant lot
and unused field as well as to that of the lot or field
whose owner is a rate-payer. Some share of this
prosperity should go to the utility, even when its
property items do not include appreciating real estate.
But, even when the earnings cover fair allowances
for hazard and for the unearned increment, the obliga-
tion of the public to the owner of the utility is not yet
ELEMENTS DESERVING CONSIDERATION 43
fully discharged. There should be proper compen-
sation for management. It is not enough to allow the
bare salaries of those who are entrusted with the
management and operation. The owner is entitled to
something more. He has brought into being and has
placed at the service of the community, an effective
organization the stability and efficiency of which is
guaranteed, as in the case of a corporation-owner, by
the character, judgment and business experience of a
board of directors selected by the stock holders. The
existence of the corporation, the business ability of its
directors resulting in the energetic control of its
affairs, the cash contribution by stock holders, the suc-
cessful operation of the enterprise, or, in the case of the
new venture, the implied guarantee of success, affords
the basis for making loans and extends the ability cf
the public to enjoy transportation facilities or electric
service, or gas and water supplies that might other-
wise long be out of reach by reason of the limited
borrowing capacity and lack of business ability of
municipal organizations. The owner should be fully
compensated for the service rendered. The mere pay-
ment of salaries to those who are actively engaged in
the management is not full compensation for this
service. The compensation for management even
though not usually specifically referred to or separated
from what might be called broadly the profit allow-
ance, makes its appearance as a part of the excess of
earnings above the actual cost of money (interest with
due regard to discounts and commissions) after allow-
ing for operating expenses and replacement require-
ments.
Volume of Business to be Considered
That there should be something in the earnings
as compensation for management can hardly be ques-
tioned. There will, however, be difficulty in bringing
the same into a satisfactory relation to the rate-base.
This is equally true of the allowance which should be
made for the participation in the general prosperity
and is true to a less extent of the hazard allowance.
All of these elements which should be covered in the
44 PUBLIC UTILITY RATE FIXING
earnings are more closely related to the volume of
business than to the capital invested in the enterprise
or to any rate-base built up from "value."
It happens occasionally that a public utility con-
cern does a large volume of business on a small invest-
ment. Some of the express companies belong in this
class. The case may readily be conceived, of such a
concern which rents its office facilities and operates
under contract with railroad and steamship companies
and which outside of its trucks and other vehicles for
local delivery, has made no investment of any moment.
It would be in vain in such a case to attempt a regula-
tion of rates based solely upon a fair return upon the
invested capital. The whole field must be brought
into view. The volume of business transacted is, in
such a case, equally as important an element for con-
sideration as is a rate-base when a limit is to be set
upon the earnings.
An express company, as here assumed, has no
appreciating property. Its share in the unearned incre-
ment of the country should be brought into some
relation to the amount of service which it renders,
that is, to the volume of its business.
The compensation for management likewise is
intimately related to and should be figured with the
volume of business as the starting point.
It would, of course, be quite as feasible to start
with the total cost of operation instead of with the
gross annual receipts when determining what should
be allowed for management and what should be al-
lowed to cover participation in general prosperity, but
the gross income as a basis has obvious advantages.
Bookkeeping will be simplified and the control is more
readily effected. The annual cost of operation will
be more difficult to ascertain and will show greater
relative fluctuations than the annual gross income, and
for the same allowance in the earnings, the per cent of
the annual gross income will be less than the per cent
of the operating cost, thus resulting in greater stabil-
ity of the percentage allowance when once fixed.
ELEMENTS DESERVING CONSIDERATION 45
From the standpoint of the public, there can be
but little question that the compensation for manage-
ment should, as here suggested, be brought into fair
relation to the volume of business instead of making
its appearance in the interest allowance on an arbi-
trarily established or assumed "going value." No
basis has yet been discovered for estimating "going
value" except capitalization of net profits. When,
therefore, "going value" deduced from the opinion of
experts, supported chiefly by assumptions, as distin-
guished from cost of developing business, is included
in a rate-base, the procedure must appear illogical
to the rate-payer and will always remain subject to
attack, both as to principle and amount. The alterna-
tive procedure which is now suggested but which is
novel and is here perhaps for the first time brought to
the attention of a court, should appeal to all concerned
as logical and in accord with the common practice in
ordinary business affairs of allowing commissions
based on the magnitude of the involved transaction.
To summarize:
No argument seems to be required to prove the
owner's right to compensation for management.
This compensation can not be brought into any
definite or satisfactory relation to what I believe
should be designated as the natural rate-base, which
is the legitimate investment, usually determined from
cost of reproduction including an allowance for cost
of developing business but without deduction of
depreciation, because the amount of business bears
no definite relation to the amount of capital invested.
If this compensation is brought into some relation
to value (including in value the going value of the
concern), then the reasoning will be in a circle and
the proceeding will be illogical and absurd.
It will always be fair to both the owner and the
rate-payer to let this compensation be brought into a
proper relation to the gross income.
The owner's share in the general prosperity of the
community, under the customary procedure of the
rate regulating authorities, is recognized in those cases
46 PUBLIC UTILITY RATE FIXING
in which the utility plant includes property which is
appreciating in value. There may be some unearned
increment, in addition thereto, concealed in the allow-
ance for "going value" and in a rate of return in excess
of the cost of borrowed money, but so long as one
concern gets the unearned increment in large amount
due to increasing values of real estate and other con-
cerns apparently get none, the system will be at fault.
The participation in general prosperity should, there-
fore, also be brought into relation to the volume of
business and not to a rate-base.
The business hazard is contingent in part on the
amount of capital which the owner has invested and
in part on the cost of operation. The allowance for
hazard if considered apart from obsolescence and from
losses due to fortuitous events, which should ulti-
mately fall on the public and not on the owner, will
ordinarily be small and, if expressed in figures at all,
can be readily brought into relation to the volume of
business. It is not logical to bring it into relation to
value which may be made up largely of intangibles.
It is not logical either to bring it into definite relation
to the natural rate-base. Hazard, too, therefore, had
best be brought into some relation to the volume of
business.
D VOLUME OF BUSINESS
Public Utility Rates and the Volume of Business
In presenting the following ideas relating to the
profit which the public utility should earn, the writer
disclaims any intent to appear as an advocate of limit-
ing the profit which the owner of the public utility can
make at reasonable charges for the service rendered
or the commodity furnished. When the owner suc-
ceeds by efficient management in keeping operating
expenses low he is entitled to a suitable reward. His
treatment by those who are charged with regulating
rates should be such that efficient management will be
encouraged and not discouraged. The suggestions
ELEMENTS DESERVING CONSIDERATION 47
which follow should be considered in the light of these
qualifying statements.
The compensation to which the owners of public
utilities are entitled for management and business
hazards, or, speaking broadly, the profit to which they
are entitled, can not be brought into any definite, uni-
versally applicable relation to the capital invested in
such enterprises. Another element, the volume of
business, deserves consideration in this connection.
That there should, in the case of every legitimate
public utility, be some profit will be admitted. This
profit will appear as an excess of earnings, present and
prospective, over a fair allowance for the use of the
money invested in the utility, provision having first
been made for operating expenses and replacement
requirements. It has been customary heretofore to
use value as the starting point when rates are to be
fixed with inclusion of some allowance for 'going
value.' The general practice also prevails of introduc-
ing into the calculation a rate of return on the so-
called "fair value" of the property, higher than ordin-
ary interest rates. Without giving special considera-
tion to the question of compensating the owner for
management and of allowing him to share in the
general prosperity of the community, which prosperity
he has helped to create, a way has thus been found to
permit the utility to yield some profit. Under such
procedure there will be cases, however, in which the
profit will be very large and may be an onerous burden
upon the rate-payer, as in the case of certain utilities
in which the amount of invested capital is large when
compared with their annual gross income and particu-
larly if the ultimate profit is swelled by the increasing
value of large holdings of real estate. And there will
be other cases in which the profit may be small and
inadequate under reverse circumstances, when the
volume of business is large in comparison with the
invested capital. As an example of the first kind,
certain water supply enterprises on the Pacific Coast
might be cited. These not only require the investment
of relatively large amounts of capital but in connection
48 PUBLIC UTILITY RATE FIXING
with some of them large areas of land are held for
reservoir and related purposes. As an example of the
second kind, certain express companies may be noted
which operate under contract with other transporta-
tion companies and which do a large business on a
small investment of capital.
Profit in Relation to Volume of Business
The proposition has, therefore, been submitted as
noted in a preceding article of this series, that the
equitable arrangement would be to bring the profit,
covering compensation for management, for hazard,
and for participation in general prosperity, into some
definite relation to the volume of business, that is, into
some fixed relation to the amount of annual gross
income.
When the procedure is followed of applying the
interest return to a rate-base determined from the
amount of capital legitimately invested, including cost
of developing the business, cost of franchises, water-
rights and the like, but without deduction of accrued
depreciation, a reasonable profit allowance should not
be difficult to determine. If the interest allowance on
the rate-base be supposed to cover the full cost of
borrowed money, due regard being had to the effect
of legitimate discounts and commissions, then certain
additions to earnings, perhaps about as below set
forth, would be fair and proper, this being in lieu of
interest on the additions to capital, which is has been
customary to make for going value, or other intangible
elements. In the last analysis the intangible values
result from the capitalization of profit. It will, there-
fore, be found simpler and more satisfactory to reverse
the usual procedure by determining what the profit
should be, instead of starting with a set of intangible
values which after all result from the capitalization of
an ill-defined arbitrary subdivision of this profit. The
following profit allowances are tentatively suggested
and remain subject to modification upon further
study :
ELEMENTS DESERVING CONSIDERATION 49
When gross income is
s $ 10,000 about 15%
I 1,500 per yi
100,000
14.5%
14,500
500,000
13.5%
67,500
1,000,000
12.5%
125,000
3,000,000
10%
300,000
5,000,000
9%
450,000
10,000,000
8%
800,000
20,000,000
7%
1,400,000
40,000,000
6%
2,400,000
100,000,000
5%
5,000,000
The allowances, here suggested as additions to the
interest return on the rate-base, are those which appear
reasonable under ordinary conditions. They should be
considered subject to modification to fit any particular
case and they will not be adequate when it happens
that the cost of the output has been materially reduced
by the introduction of a new invention which may be
the result of efficient management and skillful opera-
tion, and the use of which may entitle the owner of
the utility to larger profit for a time at least than he
would expect under ordinary circumstances.
E GOING VALUE
Going Value in the San Francisco Water Rate
Case
Referring to going value as an element deserving
consideration when "value" and rate-base are treated
as synonymous the standing Master in Chancery, Mr.
H. M. Wright, in his recent report (August, 1917) on
the value of the properties of the Spring Valley Water
Company*, says:
"Such additional value, if it is to be recognized here,
is obviously not of a separate element in the plant, as is a
conduit or a reservoir, but of the plant as a whole; an intan-
gible value, a characteristic of the unified business structure,
inhering in every part. We are here concerned, however, to
estimate this value, if possible, as if it were a separate thing."
"Going value and development expense are not synonym-
ous. One is value; the other is cost, either actual, where the
form of value is actual investment in plant, or hypothetical,
or reproduced, where the present valuation is by present mar-
ket value, or reproduction cost."
*Spring Valley Water Co. vs. City and County of San
Francisco (rate case).
50 PUBLIC UTILITY RATE FIXING
That there is always difficulty in estimating "go-
ing value" for inclusion in the rate-base is clear from
this general statement and has been universally recog-
nized. The Master quotes Judge W. W. Morrow,
who in Bonbright vs. Geary (D. C. Ariz. 1903) 210
Fed. 44, 54, 56, in an opinion awarding a preliminary
injunction, said that a going value should be allowed
but that, though often presented to him, he had never
been able to determine a proper amount upon the evi-
dence submitted. He quotes Judge W. C. Van Fleet,
of the District Court of Appeals, San Francisco as say-
ing:
"All that we are agreed upon is that upon principle there
should be a greater value attachable to a going concern than
one which is merely in its initiative and not enjoying the ben-
efit of patronage."
The law as interpreted by the courts requires that
value be made the basis of the calculation when the
sufficiency of the charges for service or for the output
of a public utility is in question, and it is for this rea-
son that the embarrassment plainly evidenced by these
quotations has resulted.
In the Spring Valley rate case already referred
to the Master refers to the difficulty of determining
going value when he says :
"It is the intangible nature of the going value which
makes it difficult to prove. * * * A large part of the ag-
gregate wealth of the world is intangible, without separate
market value or ascertainable reproduction cost. In Adams
Express Company vs. Ohio, 166 U. S. 185, the Supreme Court
sustained the taxation of an express company upon an assess-
ment of property largely in excess of the value of tangible
property. The intangible property is at one place ascribed
to franchises, and in another to good will; the name is not
important."
Justice Brewer, in delivering the opinion of the
Supreme Court in this case, uses the following lan-
guage in discussing intangible property:
"To say that there can be no such intangible property,
that it is something of no value, is to insult the common in-
telligence of every man. * * This is eminently a practical
age; courts must recognize things as they are and as possess-
ELEMENTS DESERVING CONSIDERATION 51
ing a value which is accorded to them in the market of the
world."
In the light of such opinions by our highest tribu-
nals, universal recognition of the fact that a business
may have going value is to be expected. Whether or
not it is logical or wise to include such value in the
rate-base of a public utility is another question else-
where considered.
Determination of Going Value
How can this value be measured? This is the
problem for immediate consideration and it may as
well be stated at the outset that no acceptable solution
thereof has yet been offered.
In comparing two business enterprises alike in
all respects except that the one already enjoys a fully
developed business while the other has just emerged
from the construction stage and is about to begin oper-
ation, a difference in value is readily recognized, and
the appraiser of the first, which is already a going
concern, would naturally be inclined to take the view
that the advantage which it has over the second can
be measured by the cost of developing the business
and that this cost in the absence of other satisfactory
standards may be accepted as an index of the "going
value."
This appears so plausible that many economists
and engineers have adopted a procedure based on this
reasoning for estimating going value. They have rec-
ognized, however, that while cost of developing busi-
ness can be treated as an investment of capital, that
it would not always be fair to accept the actual cost
in each individual case as representing a proper allow-
ance in the. rate-base for cost of development. If this
were done it would be equivalent to placing a premium
upon inefficiency because the actual cost of develop-
ment would naturally be greatest in the case of the
property which has been least efficiently managed. To
obviate this difficulty recourse has been had to the re-
production method with an attempt to visualize and
estimate the cost of development which would be in-
curred if under present day conditions a plant had
52 PUBLIC UTILITY RATE FIXING
to be reproduced. In the application of this method of
determining the advantage expressed in terms of
money which the going concern has over another ex-
actly the same, and in the same market, but with busi-
ness not yet established, it is necessary to assume that
some definite time will elapse between the completion
of the system and the full development of the business
as commanded by the concern whose "going value" is
to be appraised. It does not seem to the writer any
simpler or more satisfactory to thus, on the judgment
of the expert, make an assumption of the time that
would be required to establish a business than it would
be on the basis of actual experience in the same line
of business, in the locality involved and elsewhere, to
form an opinion as to what would be a proper allow-
ance for the cost of development.
In any business which is already established, an
analysis may be desirable of the various elements that
make up the intangible values of the property. In such
cases some such procedure as that of estimating the
cost of re-establishing the business under present day
conditions may be of service in segregating "going
value." But when earnings are to result from rates
yet to be fixed the case is somewhat different, and the
question will arise whether the relation between cost
of development actual or hypothetical, however ascer-
tained, is a safe guide to the going value which should
be created by the profits of the business in excess of
interest on the invested capital.
Intangible values of whatsoever nature result from
high earnings. They include not only "going value,"
but also in some cases water-right values and what-
ever may be included in such terms as "franchise val-
ue," "good will," and the like. Such values do not
exist unless the rates are higher, as the writer has else-
where pointed out they should be, than would produce
net earnings equaling the return ordinarily expected
from money loaned for use in similar enterprises.
The difficulty of using a hypothetical reproduc-
tion of an existing utility property, as a means of es-
timating the cost of developing the business, is appa-
ELEMENTS DESERVING CONSIDERATION 53
rent from the following consideration. The compara-
tive plant is assumed to be exact reproduction of the
existing plant. There is no competition between the
two plants. It might be assumed that the moment that
the comparative plant is completed, it will be in full
service at the same earning power as the established
plant. There would then be no appreciable develop-
ment period. If such a period is admitted it implies a
lack of completion of the comparative plant or the
development period should be measured only by the
time that it would take the consumer to put himself
in position to avail himself of the service. The market
in such a comparison is assumed to be at hand. The
expert who resorts to this method of estimating going
value will give his judgment wide latitude, as his con-
clusions are not apt to be convincing.
Cost of Establishing Business is not Going Value
It is well to bear in mind, however, that if a com-
munity which is served by a public utility had under-
taken the establishment of this utility as a public en-
terprise it would have been subject to the same and
perhaps greater costs in developing the local business
than the costs which were incurred by the owner of
the property. The losses in the early years, on the
same chances that there would be loss, would have
confronted the public as it confronted the private en-
terprise. The cost of establishing business is, there-
fore, an element apart and while perhaps in some
measure and under a multiplication of facts relating to
many enterprises, the cost of establishing business
may be some guide to what the normal going value
should be, it will be more logical to treat this cost
either as a part of the capital legitimately in the enter-
prise, or taking the other extreme, as a business loss
to be amortized out of earnings within a reasonable
time.
While the cost of establishing the business, includ-
ing early losses and expenditures for unsuccessful
work are not a direct measure of going value, they are,
nevertheless, in so far as they were legitimate, of that
54 PUBLIC UTILITY KATE FIXING
class of expenditures which should, as already stated,
come back to the owner of the property sooner or later.
The mere knowledge that this is the case, or the prob-
ability that the owner will some time recover them,
adds value to the property. To add them in the exact
amount shown by the cost records in any particular
case would not, invariably, be a fair procedure. The
owner who builds with care and under the best expert
advice, and who pushes his work forward as rapidly
as the market to be served will justify, and who enters
immediately upon a profitable business without any
lean years, is entitled to a reward for his able manage-
ment and the success of his enterprise. The "going
concern value" of a plant constructed under such fa-
vorable circumstances is as great as the "going con-
cern value" of other plants of a similar character but
burdened perhaps with large expenditures for unsuc-
cessful work and for the development of business.
The combined experience of all utilities of similar
character should in the long run establish the addition
which should be made to the earnings, either to amor-
tize a fair allowance for this class of expenditures in
a reasonable time or to provide an adequate return
thereon if treated as investment or as an increment
of the value of the going concern. In the light of this
conclusion it would not be fair in the individual case
to treat all losses during lean years and all unpro-
ductive expenditures during the constructive period,
such as water tunnels or wells that produce no water,
structures that fail during erection, damage by fire
and flood, earthquake or war, as additions to value or
as additions to a rate-base. These are losses and if
occurring after operation has commenced are naturally
treated as the reverse of earnings. They cannot with
propriety be added to the valuation of the physical
properties, though it may be eminently proper on ac-
count thereof to estimate the cost, of reproduction lib-
erally. In some form they should be taken into ac-
count in fixing rates. It is rarely practicable to deter-
mine such losses and unproductive expenditures with
accuracy. These expenditures and losses may be large
ELEMENTS DESERVING CONSIDERATION 55
and yet they should ordinarily be assumed to have
been incurred under competent advice. It should gen-
erally be assumed, in other words, that it could not be
foreseen that what turned out to be unproductive
work would have no value. The easy way to deal with
such expenditures is to add them to the rate-base valu-
ation, giving them a name and treating them as a
measure, in part at least, of intangible values. While
this may appear reasonable when the amount involved
is small, or not beyond what the sum of human experi-
ence would seem to indicate as fair, the other case can
readily be foreseen, as already explained, in which this
would not be so. To lay down a rule that actual losses
whether during construction or in the early years of
operation, are to be treated as elements of value is
never logical.
It should be noted, too, that there is a clear dis-
tinction to be made between the expenses ordinarily
classed as "overhead" and "development cost." The
overhead expense is an expense incurred during con-
struction and is naturally and logically made a part of
the cost of construction. The development cost is an
additional outlay during operation, which is necessary
to maintain and operate the property during the time
w r hen the receipts for commodity furnished or for serv-
ice rendered are insufficient to meet operating ex-
penses and a fair interest return on the invested capi-
tal.
Going Value the Result of Earnings
It is apparent from what has above been stated
that "going value" and the value of physical elements
are elements apart ; between which, in other words,
there is no definite relation. "Going value" then is
not dependent upon the capital which is invested in
any property. And yet "going value" grows with the
business enterprise. It is subject to appreciation. This
suggests that when once the going value is determined
which efficiently managed enterprises of various kinds
should ordinarily have, this value can be brought into
some relation to the volume of business. This thought
56 PUBLIC UTILITY RATE FIXING
has heretofore been advanced by the writer and by
others who are contending that it would be fair to
allow a going value about equal to one year's income
to be created by adequate earnings. On this point Mr.
Leonard Metcalf, a consulting engineer of large ex-
perience in valuation matters, in the recent Spring
Valley Water Company rate case, said :
"In terms of gross annual revenue, development expense
is found to be approximately equal to one year's gross revenue
as of the date of valuation, in the case of ordinary water-
works properties of medium and small size, and between one
and one and one-quarter times the gross annual revenue in the
case of the larger properties the cumulative interest during
construction charges incident to the long period of construc-
tion involved in the building of the larger works being ac-
countable for the difference."
Bearing on this same subject the writer in a
paper read in 1912 before the American Society of Civil
Engineers, said :
"The most logical course to be pursued, and the one
which is always open to the appraiser" (rate-fixing authority)
"is to use the best available means for determining the
amount of capital which is properly invested, then to deter-
mine what the earnings should be to yield an ordinary return
on the investment thus ascertained, and then to increase these
earnings by an arbitrary" (reasonable) "amount, which may
vary within wide limits, not only to compensate for past
losses and for the hazard during construction and operation,
but also as a compensation for management." And again:
"Any addition to the rate of return * * * * if there is
certainty that it will be earned, is the real basis for the in-
tangible values as they would be taken into consideration by
a purchaser."
Along the same line of reasoning Mr. Allen Ha-
zen, also of the highest standing among consulting
engineers who have devoted attention to valuation
matters, in the rate case already referred to, says :
"When a business is established and going and earning
a certain revenue, it is normally worth to the investor what
that income amounts to, capitalized on a rate of return on
other investments of equal security, and that the rate of re-
turn is normally less than the amount which a company has
to have the chance of earning, if it can, in order to induce
ELEMENTS DESERVING CONSIDERATION 57
capital to go into an enterprise of that kind; in other words,
if you want to build the Calaveras works, and you want peo-
ple to put their money into the enterprise on a chance of
earning some rate of return without any guarantee that they
will earn it simply on a chance we have to make that chance
7 per cent, we will say. Now, when the Calaveras works are
built, and if the enterprise is successful and it earns that
7 per cent on what it has cost, and is established, then the
man on the street will capitalize that income at 6 per cent
and the plant is worth one-sixth more than it cost.''
The Master in Chancery in this case upon review-
ing the testimony of Mr. Hazen, of which the above
is but a brief extract, then goes on to show what go-
ing value Would be created if various rates of return
appropriate for a going plant and a like plant ready
to begin business were assumed. It is with some sat-
isfaction that the writer makes note of these facts
and of the endeavors by others to lay a basis in the
earnings for "going value," because they confirm his
conclusions that this basis lies there and that the re-
sult of the capitalization of the earnings should not
make its appearance in the rate-base. (See preceding
chapter.)
May we not conclude then, that in the case of
the public utility which is subject to regulation, its in-
tangible values arise from some allowance in the earn-
ings, in excess by some predetermined amount of the
earnings, which would just yield a proper rate of in-
terest on the actual capital reasonably and properly
invested. When the sum of all intangible values is
thus determined (by capitalization of a part of the
earnings) it will matter little what name is used to
designate them. But the increment of earnings in ex-
cess of the ordinary interest rate on investments, in
safe going concerns, should be so fixed to cover also
any amortization made necessary by obsolescence, or
loss by fortuitous events, and to cover whatever allow-
ance is to be made as compensation for management
and as a share in general prosperity, possibly in lieu
of appreciation. When the limitation of this excess
by rate fixing authorities is under consideration, it can
probably be more nearly standardized by bringing it
68 PUBLIC UTILITY RATE FIXING
into some definite relation to volume of business, than
in any other way.*
*See "Public Utility Rates and the Volume of Business,"
page 46.
LAND ADAPTED TO SPECIAL USE 59
CHAPTER III
APPRAISAL OF REAL ESTATE ADAPTED TO
SPECIAL USE
The Value of Reservoir Lands
No definite solution of the problem how to
determine the value of reservoir property has yet been
devised. There is, in fact, no recognized rule by which
the market value of any property which has peculiar
adaptability for some particular use can be determined.
No other course is open in ascertaining the value of
such property than to determine the effect upon the
market of a knowledge of all the circumstances bear-
ing upon each case.
Circumstances Affecting the Value of Land
Speaking generally of the value of real estate, it
may be said that the effect of all factors which influ-
ence its market value is reflected in the valuations
made from time to time by experts, and by the courts
or other public authority, and also by the sales of
which knowledge is obtainable. The essential element
of rental value or productiveness will be presently
referred to. As the previous valuations and records
of sales of similar property do not apply to the time
at which the valuation is being made, some attention
must be given to the rate at which the value of real
estate, expressed in terms of money, has been ad-
vancing. For the region on both sides of the south
arm of San Francisco Bay such a study has been made
and the results thereof are hereinafter presented. This
study has been extended to five of the bay counties
and to the entire State of California and covers not
alone the rates at which real estate values have been
increasing but also the rate of population growth.
As population increases the uses to which land
can be put with profit are advanced from lower to
higher uses. The value of land will go up as the
60
demand for its higher use becomes more insistent. If
any tract of land taken at random be considered, its
value will go up in some relation to the increasing
density of population in its vicinity. The more remote
that it is from a population center and the smaller the
demand of society that it be put to beneficial use, the
more difficult will it usually be to trace the effect of
the growth of population on its value. For a time the
supply of land on the frontier is so large that the
value thereof may not be determinable from the return
that can be realized by using it in any particular way.
But even in the case of the frontier land it will be
found that as the demand of society for the beneficial
use thereof increases its value will increase. When
the time can be forecast with some degree of certainty,
at which the land will be in demand for any particular
use, the basis for estimating value begins to assume
definiteness. When finally, under use for certain
purposes, the land can be depended upon to produce
income, the basis of its value, in part at least, becomes
positive. It may, nevertheless, still continue to have
more or less speculative value due to its proximate
requirement for higher uses.
Ordinarily when the value of land is in question,
the return which the land produces in rents or other-
wise, or the return which it may reasonably be hoped
to realize in the future, as also the sales of other sim-
ilarly located property adapted to similar uses can be
used as guides to a determination of market value.
The actual sales are valuable, if there have been any,
because they furnish more or less dependable evi-
dence of the effect of all known circumstances upon
the public mind in the matter of land value. But when
land is under consideration which is in use or which
is available for use as a storage reservoir there is
usually no such index of market value which can be
applied. It would be an unusual circumstance to
find sales of recent date of similar property that would
with any definiteness demonstrate the market value.
Neither is the rental value of such property for the
reservoir use to which it is specially suited, ascertain-
LAND ADAPTED TO SPECIAL USE 61
able, even when already in use, because actual com-
petitive demand for such property is usually out of the
question and it is not practicable to so apportion the
net return of the water supply business that the
amount thereof which should be ascribed to the use of
the reservoir lands and which might be a key to rental
value can be ascertained.
Factors to be Considered in Determining Market
Value of Reservoir Land
There are, nevertheless, many circumstances
which, when properly understood, will have an effect
upon the market value of reservoir properties. Such,
for example, are the time when the use of the reser-
voir site in question will be a necessity, and the time
when the water supply commanded and made avail-
able by the reservoir will be in full use ; also the exist-
ence and relative availability of other storage sites or
other sources of water ; the location of the reservoir
site and all circumstances affecting the cost of devel-
oping the storage and of developing the water, partic-
ularly when the reservoir site is not yet in use nor
immediately requisite; also the extent to which the
availability of any particular site has been demon-
strated by the actual construction of works and the
impounding of water ; the quality of the water, and
every circumstance relating to valuations theretofore
made by competent authority of the property in ques-
tion or of other like properties, whether for rate-fixing
or other purposes.
Consideration should therefore be given :
To the adaptability of the site for use as a reservoir.
To the necessity for such use immediately or in the near
future and to the continuance of such use.
To the fact that the reservoir lands have been assem-
bled in one holding.
To the question of whether or not the serviceability of
the reservoir site for water storage has been demon-
strated by actual use.
To the cost of the lands and their increase in value
since the time of purchase.
To the valuations of these and other reservoir lands
62 PUBLIC UTILITY RATE FIXING
heretofore determined or ascertained by rate fixing
authorities and by the courts.
To the service rendered or to be rendered in the matter
of the amount and quality of the water and the ad-
vantages or disadvantages of the location of the res-
ervoir site, particularly when one of the functions
of the reservoir is to safeguard a supply.
None of these factors taken separately leads to a
determination of value which could be accepted with-
out question. Any or all of them may influence a
willing seller or a prudent purchaser in determining
the sale or purchase price of such properties and they
all, therefore, must be regarded as having more or less
effect upon market value.
Any evidence furnished by sales of similar prop-
erty should be carefully examined and should not. be
too heavily weighted. In the case of any individual
sale there may have been lack of information on the
part of the seller of the full market value of the land
or the sale may have been prompted by other consid-
erations than the price obtained for it. Consequently
but little dependence can ordinarily be placed on any
s : ngle real estate transaction.
It is the multiplication of these transactions which
makes them, presumptively at least, an index of the
judgment of the public relating to market value. The
fewer the number of transactions and the greater the
uncertainty relating to the circumstances in each
thereof, the less dependable will any such index
necessarily be.
The elements which determine the utility of a
reservoir area for the development of a water supply
by storage are in the main:
1. A fairly level area of considerable extent enclosed
or nearly enclosed by higher land, forming a basin which may
have an outlet and possibly in addition one or more low
places or secondary outlets in the surrounding rim land, all
of which can be closed by dams.
2. A tributary watershed from which the run-off due to
snow and rainfall is sufficient to be worth while, after allow-
ing for evaporation and other water losses from the reservoir.
LAND ADAPTED TO SPECIAL USE 63
3. A geologic formation such that the construction of
the necessary dam or dams is feasible and water losses from
the reservoir will not be excessive.
4. A location and topographic configuration such that
the cost of structures will not be prohibitive.
5. A market, present, or prospective, for the water
supply which will be made available.
In the case of a storage reservoir the prime pur-
pose of which is to hold a supply of water in reserve,
for emergency use, and whose serviceability as a
producer of water is secondary, an element of first
importance in determining its utility will be location
in reference to the district to be served and in relation
to the other works for the supply of the district.
The function of the storage reservoir, broadly
stated, is to bring the natural flow of the stream which
feeds it under control, so as to make better utilization
possible and to reduce waste. Without a storage res-
ervoir the limit of utilization at any particular time is
the discharge of the stream at that time. In the
vicinity of San Francisco stream flow fluctuates within
wide limits. Under the peculiar climatic conditions
of the Pacific Coast the stream which flashes up to a
large discharge and flood stages, under the influence
of the winter rain storms, may dwindle to insignif-
icance in the long dry period of summer or in the
interval between the intermittent rains of the winter
months. As a source of water for use in supplying
the needs of the inhabitants of a city, such streams as
those controlled by reservoirs in the San Francisco
bay region would be of but little value without storage
reservoirs. Nevertheless, in any strict analysis of
the service rendered by a reservoir in increasing the
water supply from the stream which feeds it, some
account should be taken of the additional amount of
water (that is of the water in excess of that obtain-
able from the stream in its natural condition) which
the reservoir makes available. Under California con-
ditions, in the Coast Range and in the lower portions
of the Sierra Nevada this is frequently the entire
possible water output, because without storage the
64 PUBLIC UTILITY RATE FIXING
obtainable dependable continuous supply measured by
the minimum natural flow would not justify utiliza-
tion.
It is, of course, different when water is required
intermittently and in coincidence, or nearly so, with
the natural large flow in the stream as may be the
case when water is used for irrigation. Thus, for
example, a large part of the snow which falls during
the winter months in the high Sierra Nevada Moun-
tains, melts and appears in the stream in the spring
and early summer months at the very time when
water is in demand for irrigation. When, on a stream
which carries this water, storage is provided, there
will be better control of the flow, wastage will be
reduced, and water may be held over from a season of
abundant run-off to another in which the natural flow
is light, but the condition will rarely prevail under
which the storage reservoir could be given credit for
the entire amount of irrigation water developed and
withdrawn from the stream.
The utility of the reservoir in such a case is
measured by the improved service which it makes
possible and by the reduction in the amount of water
that without the reservoir would go to waste.
In view of the conditions as they prevail in the
San Francisco Bay region the comparison of storage
reservoirs here, whose water is used to supply the
needs of the residents of cities, can best be made on
the basis of the water output or yield per acre of
ground covered by the reservoir. But in addition,
other factors, such as the amount of storage per acre
of reservoir, and the location of the reservoir may also
require attention and, of course, too, the suitability
of the water for the uses to which it is to be applied.
Attention may be called in this connection to the
fact that there may be reservoirs of so large an extent
that their value per acre of reservoir surface is small.
The case of a lake may readily be conceived which
has a large surface area and which with a low, perhaps
inexpensive dam, will store a large amount of water.
From such a reservoir the loss of water by evapora-
LAND APPLIED TO SPECIAL USE 65
tion will be relatively large and it may well be that
the water production will now and then be negative,
that is, there will be occasional years with less inflow
into the lake than is required to make good the evapo-
ration. As an extreme example of this kind, Goose
Lake, in the northeasterly corner of California may be
cited. For more than a half century there has been no
outflow from this lake. As a storage basin in the
ordinary sense this lake would have no value. Tulare
Lake is another example. Occasionally in such sea-
sons as 1861-62 and 1867-68 the lake has been full and
during a series of years when at or near a full stage,
has contributed to the flow of San Joaquin River. But
some forty years have now elapsed since there has
been any outflow from the lake. The evaporation from
the large area that is exposed to evaporation when
there is water in the lake offsets the inflow in ordinary
years.
To make the lake a dependable source of water
provision must be made to draw down its water to
lower levels, thereby reducing the water surface area
and decreasing the annual evaporation.
Other examples can be cited of lakes which are of
so large an extent that their value as storage basins is
low when compared with other reservoirs of the same
storage capacity but of less surface extent.
There may be instances, too, though in the case of
storage reservoirs they appear as exceptions rather
than as the rule, where the superior function of the
reservoir is to hold water in reserve to be available in
case of accident to the system as ordinarily in use.
Under such circumstances the value of the reservoir
n ay not depend upon its water production but rather
upon its location and storage capacity. A case in
point is Merced Lake, located within the limits of San
Francisco, which rendered such valuable aid as an
ample emergency source of water in 1906, during the
time that, as the result of the earthquake and fire, the
main lines of San Francisco's water supply were
temporarily out of commission. Water from this lake
is in use in small quantity, about 3,000,000 gallons per
66 PUBLIC UTILITY RATE FIXING
day. It is expected that this use will cease in the near
future when an additional supply of water is brought
across the Bay from the Alameda and Calaveras Creek
systems. As an emergency source of water the lake
will thereafter continue to have value, but this value
can not be brought into any satisfactory relation with
the value of other more remote storage sites on the
basis of water production or utilization which for
Lake Merced may soon be so small as to be negligible.
Such factors as these are among those to be
considered when the water production from reservoirs
or the value of reservoir land is to be determined.
Appreciation of Land Value
The value of reservoir land is not necessarily
greater than the value of the same land for other uses.
The case may readily be conceived where alternative
uses will create values in excess of the amount which
could economically be invested in the reservoir prop-
erty. Under such circumstances either the necessity
for the utilization of the site does not exist because
alternative sites are available or the water-works sys-
tem must get along without the storage which the
reservoir would have afforded.
The problem of determining the market value of
reservoir lands is one of the most difficult that can be
presented to the engineer. The question is not what
such lands may be worth as a part of a water-works
system and how great the sacrifice which an owner of
such water-works would make rather than to be de-
prived of the use of the reservoir, but what is their
value in the hands of an owner not in the water supply
business as determined by the competition for their
acquisition that would exist between various parties
who could utilize them sooner or later for reservoir
purposes. The problem will involve the weighing, in
each case, of all attendant circumstances. This is par-
ticularly true when, as in the case of the Spring Valley
Water Company's reservoirs on the San Francisco
peninsula, the sites occupied are the only ones of their
character which are available to adequately fulfill their
purpose.
LAND ADAPTED TO SPECIAL USE 67
When the reservoir site to be valued is not
already in use but the necessity for its use is pressing,
it may be proper to determine an upper limit of value
by comparison with the next most available source ot
supply. But any limit thus ascertained is not market
value, though it may occasionally be the measure of
what the party desiring to use the reservoir property
can afford to pay.
Increasing Land Values in the San Francisco
Bay Region
Referring now to the increasing value of land in
the San Francisco Bay region, the statement may be
repeated that land taken in its entirety is increasing
in value. Values are increasing not alone at and near
population centers but also in broad zones which are
more or less directly under the influence of these popu-
lation centers, and, in fact, wherever population
growth and the resulting modification of transporta-
tion facilities, by rail, by water or on improved high-
ways have affected or are likely to affect, in not too
remote future, the use to which the land can profitably
be put.
While this is true and while the possibility is
recognized of developing a law approximately true,
connecting land value, measured in terms of money,
with population or regional density of population,
there will always be local exceptions to any such law.
There may be localities too, where the change due to
environment will be from a higher to a lower use
where value will decrease instead of following the
general law of increase. Furthermore, regularity in
the rate at which land values advance is not to be
expected. A long continued, well defined upward
movement in land values has repeatedly, in the history
of this country, resulted in over-speculation, creating
temporary unwarranted or fictitious high values trom
which there was thereupon a recession <>r beyond
which there would be no further advance until, in the
course of time, due to all the factors incident to
68
PUBLIC UTILITY RATE FIXING
growth of population and the demand of society for
fuller utilization still higher value was created.
/7/>/ jfVlELi . (3)
/Mi -7 -Y;--
( (/-t-/;'/
The current depreciation as correctly determined
by equation (2) will always be larger than that found
by the ordinary method equation (3) because :
In the case of the determination of present value
if expectancy be made the basis of the calculation, as
is the common practice, the formula for the present
value of an article whose original cost was $100 is as
follows :
Present value
(4)
Let consideration be again given to two similar
articles, the probable life of each of which when new
was n years and whose expectancy at the time when
valued was e years, and whose history shows that
one went out of use s years before its predicted date
of failure while the second continued in use for the
same number of years beyond this predicted date.
These two articles may stand for any number of arti-
cles whose actual terms of service will, in part, fall
short of and will in part extend beyond the original
probable life term, which is the problem for any group
of articles all of the same expectancy.
We have again
nij = m + s for the article that fails first, and
94 PUBLIC UTILITY RATE FIXING
m, = m s for the article that falls last.
From the above formula :
Pres. val. of the first article .-.-_ M [/_ ( /+/ ) />7 ~
( (/+/)*-/
f (/ 4. /)>*->_
Pres. val. of the second article - /oo \ I -- - - ' - -
I (/+/)*/
Pres. val. of the two articles
Determined on the basis of expectancy without
regard to the fact that one-half of any number of arti-
cles must be expected to and probably will fail before,
and the other half after the predicted date of failure,
the present value of the two articles would be ex-
pressed by :
Pres. val. of both articles (ord. formula)
(/+/)*-/
and because n e = m
Pres. value of both articles (ord. formula)
But (/+/)"
Consequently the formula (5) containing the
larger negative term will always give results some-
what smaller than formula (6). By the use of ex-
pectancy and ordinary formulas, therefore, the pres-
ent value would be estimated somewhat too large.
Fortunately, the errors introduced by using the ordi-
nary formulas based on sinking fund methods of cal-
culation are not a matter of great importance because
the basic elements to be taken into account, the prob-
able life new and the expectancy after a period of serv-
ice, are approximations based on expert judgment and
may be at considerable variance with actual facts.
DEPRECIATION AND APPRECIATION 95
Determination of the Current Replacement
Requirement Essential
Here is an additional reason why value should not
appear in the rate-base. But even though the necessity
of computing accrued depreciation and present value,
falls away when rates are to be fixed, the other prob-
lem of estimating the replacement requirement is ever
present. The replacement requirement is often, though
loosely, referred to as offsetting current depreciation.
The allowance in the earnings is then referred to as an
allowance for depreciation. This allowance thereby
assumes the aspect of an amortization of capital to the
extent that there has been lessening of worth and
lends plausibility to the use of the remaining or pres-
ent value of physical elements in the rate-base. That
this is not necessary for correctly estimating proper
earnings has been fully demonstrated by the author
in "Valuation, Depreciation and the Rate-Base," and
in various papers contributed to the Transactions of
the American Society of Civil Engineers and the dem-
onstration need not be repeated here. It is only neces-
sary to say that any money accumulating in a fund for
replacements should be regarded as being at the dis-
posal of the utility owner for any purpose and that,
theoretically, in so far as the ultimate result is con-
cerned, it would make no difference whether the own-
er is allowed an interest return on present value plus
so-called current depreciation estimated from remain-
ing value and remaining life or whether he is allowed
interest on full value new (original investment) plus
the replacement or depreciation increment which will
in the life term provide the funds necessary for re-
placement, provided always that the life term of any
article in question could be known in advance.
Consideration of this fundamental truth, coupled
with the fact that accrued depreciation is not sus-
ceptible of precise determination, has led the author
to recommend for general application the procedure
which he has named the "Unlimited Life Method of
Procedure," under which a clear distinction is made
between value and rate-base and under which provi-
96 PUBLIC UTILITY RATE FIXING
sion for replacements is to be made as required, being
treated as though replacements were repairs on a large
scale, to be foreseen before the necessity arises to
make them, and under which therefore the earnings
should be ample to provide a fund out of which either
to meet the replacement requirements or to reimburse
the owner after they have been made.
Appreciation in Relation to Rates
The value of an income producing property is
ordinarily determined from its earnings. As its net
earnings increase its value increases. There may be a
material increase of value, therefore, without any in-
crease of investment. The earning power of public
utilities, as a general rule, if rates remain stable, in-
creases as population increases, although not neces-
sarily in the same ratio. The appreciation or increase
of value which results when net earnings, in their re-
lation to the investment, are increasing follows no
definite law and it cannot be forecast with that degree
of certainty which can, with some reason, be claimed
for depreciation. Just as depreciation represents a
loss so does appreciation or increase of value without
increase of investment represent a gain. It is an un-
earned increment which results from the changing con-
ditions of environment.
Usefulness in service, and therefore value, does
not always decrease, but may sometimes increase with
age. This may be the case with a dam, or with a rail-
way embankment which become more dependable with
advancing age. Increasing value may also result from
an advance in the price of labor and materials, or from
changes in the conditions u.nder which an enterprise
was first established which would render more expen-
sive the construction or establishment of the enterprise
under the altered conditions.
Stated broadly, values as expressed in terms of
money are increasing. This applies not alone to the
value of real estate and water rights and like proper-
ties, but also, the same condition of serviceability be-
ing assumed, to physical elements generally, and to
DEPRECIATION AND APPRECIATION 97
intangibles. It is also true that, as a general rule,
public utilities are to be included among the prin-
cipal factors which are responsible for the growth of
communities, and that when viewed in this light, the
owners thereof are entitled to participate in the un-
earned increment or in the general prosperity just as
the land owner participates. They do so, of course, as
their business increases, but if held down to earnings
which will only yield the ordinary interest rate on safe
investment or only the interest at which, for use in
similar enterprises, money can be borrowed, the ex-
tent of sharing in the general prosperity may fall far
short of the rate at which values generally, and par-
ticularly land values, are advancing.
Appreciation Referred to in Court and Public Service
Commission Decisions
Such considerations, although not thus expressed,
have led the United States Supreme Court to hold
that the owner of a public utility is entitled, in most
cases at any rate, to have the present value of his prop-
erty made the basis of the computation w T hen rates are
to be fixed. In the Consolidated Gas Co. case (Wm.
R. Willcox et al. vs. Consolidated Gas Co. of N. Y.,
212 U. S. 19), the court says:
"And we concur with the court below in holding that the
value of the property is to be determined as of the time when
the inquiry is made regarding the rates. If the property
which legally enters into the consideration of the question
of rates has increased in value since it was acquired, the com-
pany is entitled to the benefit of such increase. This is at
any rate the general rule. We do not say that there may
not possibly be an exception to it where the property may
have increased so enormously in value as to render a rate
permitting a reasonable return upon such value unjust to the
public."
If this view be accepted, as it is by those who
consider rate-base and present value synonymous, the
question is where to stop. Must this matter of adding
appreciation and allowing a return thereon as though
it were additional investment go on forever." If this
is the theory its application will hasten universal pub-
98 PUBLIC UTILITY RATE FIXING
lie ownership of public utilities. Should not a limit
be set and thereafter the rate-base remain unaffected
by appreciation? The allowance for appreciation, or
better, an allowance for participation in general pros-
perity, should then appear in the earnings. The owner
should be allowed a fair amount of current apprecia-
tion with which he may do what he pleases, and the
public will hold down the rate-base to what is esti-
mated to be the properly invested capital at the time
the rate-base was established. The court has appra-
rently overlooked the fact that an unearned incre-
ment can be thus allowed in the earnings, and that if
thus allowed the public utility which has no appreci-
ating real estate will fare as well as those public util-
ities which own large areas of land or other appreciat-
ing properties.
Rental Compared with Ownership
In weighing the question whether or not appre-
ciation is to be added to the rate-base, consideration
may be given to the alternative of the rental value of
equivalent property. Suppose for example that among
the properties owned by a public utility there is a
large tract of land located in a region in which real
estate values are advancing normally. If instead of
acquiring this land the owner of the utility had en-
tered into a lease thereof based upon an agreement
that the rent from year to year should be commensu-
rate with a proper valuation of the land, the amount
of the rent increasing from year to year would be in-
cluded in the cost of operation and rates would be fixed
as though, in the case of actual ownership, the rate-
base had included appreciation.
\Yhile by such reasoning a sound foundation may
be laid for the inclusion of appreciation in the ap-
praisal of the rate-base, there will always be some
cases in which appreciation has been so great that it
would be unfair to the rate-payer to let the full bene-
fit thereof go to the owner of the utility. Why should
not the public, and particularly the rate-payer, be al-
lowed to participate in a measure in the unearned in-
DEPRECIATION AND APPRECIATION 99
crement which is the result of general prosperity and
development of resources and, therefore, in part at-
tributable to the presence of the rate-payer? Not only
may such questions be asked, but it will be proper to
consider that while it may be a simple matter to deter-
mine from time to time the appreciating value of land,
this may be difficult and uncertain in the case of other
kinds of property.
The Interstate Commerce Commission Has Difficulty
in Dealing with Appreciation
The difficulty of conforming to the decision of the
United States Supreme Court in the matter of allowing
the appreciation of real estate was felt by the Inter-
state Commerce Commission of the United States,
which says in its opinion in the Western Advanced
Rate Case (20 I. C. C. Rep. 344, decided February 22,
1911):
"Certainly if the Supreme Court may decline to lay down
the absolute rule that 'in every case failure to produce some
profit to those who have invested their money in the building
of a road is conclusive that the tariff is unjust and unreason-
able' (Reagan vs. Farmer Loan and Trust Co., 154 U. S. 412),
it is a conservative statement of the law to hold that a rail-
road may not increase the rates upon a number of commodi-
ties solely because its real estate has risen in value."
"While it is evident, therefore, that each case must be
decided upon the facts peculiar to it, the Commission believes
it proper in this case to follow the general rule, as stated
by Judge Hough of the United States Circuit Court (Consol-
idated Gas Co. vs. City of New York et al., 157 Fed. Rep.
849, 855), 'Upon reason, it seems clear that in solving this
question the plus and minus quantities should be equally con-
sidered, and appreciation and depreciation treated alike.'
* * * Thus land has been taken at its fair value and not
at its original cost, and the annual appreciation of land has
been treated as a profit. By this method all property is
treated absolutely alike, as Judge Hough suggests. No dif-
ference is made, except that as depreciation represents a de-
crease in assets, it is placed as a debit against operation,
while appreciation is placed as a credit because it is an in-
crease in assets."
100 PUBLIC UTILITY RATE FIXING
Treatment of Depreciation and Appreciation
Compared
The difference between the ordinary treatment of
depreciation and of appreciation results from the fact
that in the case of depreciation, which is continuous
and can be estimated, a definite annual allowance can
be made in the earnings to offset it, while in the case
of appreciation, which cannot be estimated from year
to year, it is not ordinarily treated as revenue. When
the occasional appraisal discloses appreciation it is
treated as profit. The Interstate Commerce Commis-
sion believes that depreciation and appreciation should
be treated alike. The United States Supreme Court
holds that the owner of the public utility is entitled
to the appreciation unless the same is excessive in
amount. It would be much simpler, as already stated,
to grant to the utility, after a rate-base has been prop-
erly determined, some reasonable share in the general
prosperity not measured solely by the value increase
of real estate and other property, and preferably
brought into some relation to the volume of business
instead of to the rate-base. Under the ruling of the
courts, however, in determining present va!ue there is
no escape from a consideration of reproduction cost
and the reproduction cost will include appreciation.
Under this ruling all relation between actual original
cost and permissible earnings may be lost. \\ hen the
courts shall have accepted the view that "fair value"
is not the proper starting point, then the importance
of making a close estimate of cost of reproduction,
which includes both depreciation and appreciation,
will fall away.
THE VALUE OF A WATER RIGHT 101
CHAPTER VI
THE VALUE OF A WATER RIGHT
Recognition of Value
When water is used for irrigation it makes the in-
tense cultivation of the soil possible. It aids, as stated
in a preceding chapter, in producing crops which can
be marketed at prices not subject to regulation except
by the law of supply and demand. The availability
and use of the irrigation water modify the character
and increase the amount and consequently the value
of the crop. These elements may thus add an incre-
ment of value to the irrigated land. Under such use,
the value of the water at the field and, upon allowance
for the cost of development, its value at its source can
be determined. Water and water rights in districts
where water is used for irrigation acquire, in conse-
quence, a recognized market value, depending upon
the resulting appreciation of the land, upon the value
of the crops harvested in relation to the cost of pro-
duction, and upon the cost of developing and making
the irrigation water available.
When water is taken from a stream for uses which
decrease or otherwise modify the natural flow of the
stream or when works are constructed which raise or
lower the water plane of the stream the rights of ripa-
rian owners may thereby be aiiccted. Contemplated
diversion can not be made nor can proposed works be
constructed in such cases, without making compensa-
tion to the riparian owners for the resulting damage to
their property, except of course when such owners
sleep upon their rights.
To the extent of the cost of extinguishing the ripa-
rian rights and possibly of securing other water rights
whose use is secondary or which for anv reason should
be merged in one holding, there is then-- a public util-
ity being under consideration an investment to be as-
sumed in that intangible element the water riirht.
102 PUBLIC UTILITY RATE FIXING
Sometimes by reason of local development and
high values of riparian lands and the use of the stream
flow for power, the cost of settling with the riparian
owners and of eliminating adverse users of the water
may be large. At other times the situation is such
that equally good rights to use water can be secured
without any cost except the cost incident to the con-
struction of the project features and the acquisition of
the necessary lands and rights of way.
The fact that in the first case it will have to be
conceded that the owner of the public utility is entitled
to have the cost of the water right which he holds
made a part of the rate-base and that at least to the
extent of cost (reasonable and actual proper cost being
assumed) this water right has or should be made to
have value, justifies the public in concluding that the
other water right which has cost nothing should have
a similar value whether the same be made a part of
the rate-base or not. Water rights applying to water
whose use is demanded by society, are then to be re-
garded as having market value. When the water is
developed and is in use or is available for use or when
the need of putting the water to beneficial use is prox-
imate, the existence of such value is easily recognized.
When an investment has been necessary to eliminate
adverse rights and to meet other expense of securing
the water right, the propriety of including its cost in
the rate-base is unquestioned.
According to the decision of the U. S. Supreme
Court in the case of San Joaquin and Kings River
Canal and Irrigation Company v. the County of Stan-
islaus, California, the water right must receive the
same consideration as other property when rates are
to be fixed. But the court does not attempt to settle
the question of how a water right is to be valued.
The right to appropriate flowing water and to put
the same to beneficial use is given by law, in most of
the Western states, to any one who will construct
proper works for the development of the water and for
its transmission to places of use. The water of the
stream is reserved to the public. The grant of the
THE VALUE OF A WATER RIGHT 103
right to take water from a stream and put it to some
beneficial use is comparable with a franchise. This
right may have value for the same reason that a fran-
chise or intangible element of property may have
value, that is because the exercise of this right may
result in net earnings creating value in excess of the
investment in physical property. Whether the market
value of the water right, or the investment that was
made to secure it, is to be made a part of the rate-base
will depend upon whether value or the investment is
to be made the starting point when rates are to be
fixed.
The courts and the rate fixing authorities, accept-
ing the view of the public, but still generally adhering
to the fiction that fair value is the basis of the calcula-
tion, not only hold that water rights may have value
but that they should appear at their market value in
the rate base. But neither the courts, nor public serv-
ice commissions, nor valuation experts, have yet dis-
covered any dependable method of determining this
market value.
Regional Cost of Development Considered
The method of estimating the market value of a
water right in the case of water used to supply the
needs of an urban population, by comparison with the
ordinary or average cost of developing water in the
same region in like amount, of like quality and under
similar conditions of deliver)', has occasionally been
applied, but not with satisfactory results.
To illustrate, let it be assumed that the average
ordinary cost of supplying water for domestic use in
the region in which water right is to be valued is 10
cents per 1000 gallons. This amount is here supposed
to include interest on the investment and cost of opera-
tion. Let it be further assumed that the cost of sup-
plying by the system whose water rights is to be val-
ued has been found to be 9 cents per 1000 gallons. A
comparison of these costs of supplying water indicates
that the value of the water right under appraisal is as-
certainable by the capitalization of 1 cent per 1000 gal-
104 PUBLIC UTILITY RATE FIXING
Ions. It will readily be seen that under such circum-
stances a rise of 10 per cent or 1 cent per 1000 gallons
in the average regional cost of water production would
have the absurd effect of doubling the value of the
water right.
Furthermore, in the case of every ascertainment of
average regional cost those properties which are least
favorably circumstanced must fall above the average
to offset those which fall below. The former may
nevertheless be entitled to the same standard of treat-
ment as is accorded the latter. And yet, under this
test of value, all of those whose cost of developing
their supplies exceeds the average, would have to con-
sider their water rights liabilities and not assets. This
is an absurdity and condemns the method.
Neither this method nor a comparison with the
cost of developing the next most available supply can
be used as a dependable method for determining' wa-
ter right value.
In some sections of the country, as for example in
certain portions of California, the demand for irriga-
tion water has nearly if not quite reached the limit of
supply. In such regions the depressing effect upon the
value of water rights which results from large unde-
veloped available sources is no longer felt. The earn-
ings that result from the use of the water are large and
have become the measure of value and this value is
consequently relatively high.
The value of water rights in such sections has an
effect upon the value of water rights elsewhere and for
uses other than irrigation. The value of water used
for domestic purposes, domestic use being imperative,
should not be less than that of water used in the same
locality for irrigation and if for this purpose it has a
high value in one part of the state the question is
asked why not in another? Such considerations as
these are not without effect upon the maket value of
water rights.
To the extent that the value of a water right as
taken into the rate-base other than the natural rate-
THE VALUE OF A WATER RIGHT 105
base of a public service property exceeds the cost of
the water right, the owner is conceded a profit or re-
ward for undertaking the development, and this profit
or compensation increment might reasonably be ex-
pected to bear some definite relation to the general
cost of developing water in any region.
The practice of thus making a reasonable allow-
ance for water right value, preferably a percentage al-
lowance for the ordinary regional cost of developing
water resources, has not yet been anywhere estab-
lished, but in the writer's judgment would have merit.
If this practice were generally adopted, it would result
in fixing with some definiteness the value of water at
its source and would remove much of the uncertainty
that now obtains in relation to the value of water
rights. Moreover, if thus determined, the value of
the water right would not be subject to unreasonable
fluctuation nor to too wide a range. Where the re-
gional cost of development, including everything
necessary to make the water available for distribution
is 10 cents per 1000 gallons and the allowance for wa-
ter rights is to be about 10 per cent of this amount, or
1 cent per 1000 gallons, a departure of 1 per cent in
the cost of water development from this regional av-
erage would only modify the value of the water at the
source by 0.1 per cent. A 10 per cent departure would
be necessary to affect this value by 1 per cent. In
other words, when once an amount has been agreed
upon and generally accepted as a proper allowance to
be made for the value of a water right or rather,
when such value is to be created by a suitable allow-
ance of earnings, this value will be fairly stable and
being then readily ascertainable, will thereafter when
definitely recognized by the public, pass as the market
value.
Strategic Value
But in addition to the basic value at its source, a
water supply may have additiional value due to an es-
tablished market and an inherent advantage of quality
and location and to other circumstances that determine
106 PUBLIC UTILITY RATE FIXING
its development cost in comparison with the develop-
ment cost of competing supplies. Such value may be
termed "strategic value."
To illustrate, a riparian ownership which controls
a water power may be cited. The case may readily be
conceived of such a water power, limited in amount,
which is completely controlled by a riparian owner.
When such a source of power is to be valued in a re-
gion where the market for power is good, where, for
example, the water power will be delivered to a market
in which it displaces a like amount of power generated
by steam, the cost of the latter in comparison with
the cost of the former, affords a legitimate means of
determining value or, better stated, ordinarily an up-
per limit of value. The valuation becomes a simple
matter when, under such circumstances the power is
already fully developed and is in use or is being sup-
plied to a market which takes it all. But when, the
market for power is undeveloped, some consideration
must be given to the uncertainty of achieving the ex-
pected results and due allowance must be made for
the time that will have to elapse before a return from
the sale of power can be realized.
There will, of course, be cases in which an analysis
of the cost of generating and delivering power will
show the advantage to be with the power developed by
steam. This may obtain when from any cause, such
as an irregular water supply, the load factor on the
hydro-electric plant is unfavorable or when the cost of
water development and transmission of power to the
place of use is materially higher than it \vould be from
a properly located steam plant. In such cases the
hydro-electric enterprise may nevertheless be a legiti-
mate one. It may have been initiated when the price
of fuel for generating steam was such that the ad-
vantage of cost was temporarily with the water power ;
or the margin in favor of the steam power may be so
small that the recognized advantage and economic
value to society in conserving the energy which annu-
ally reappears in the water of the stream outweighs
any financial disadvantage that may appear from a
THE VALUE OF A WATER RIGHT 107
comparison with steam as a source of power, and justi-
fies earnings that might not under other circumstances
be considered reasonable.
Water Power Development Should Be Encouraged
In concluding the foregoing article a reference
was made to the economic value to society which
results from the development of the energy in flowing
water. Any one who engages in the business of con-
trolling and marketing this energy deserves not only
adequate protection of his investment, but also some
reward for doing that which conserves other valuable
natural resources.
Under this view, even when the water right which
makes the development of power possible would ap-
pear to be without market value at current fuel prices,
it will be reasonable to allow to the owner not alone
a rate-base increment equal to the cost of securing the
water right, if there has been any such cost, but also,
if this cost has been legitimate and reasonable, a fair
excess allowance in the earnings, perhaps proportional
to the amount of power developed rather than to the
actual investment in works for developing and market-
ing this power. But this can only be done \vithin
limits or so long as the rates for the service remain
reasonable. When it would require excessive rates,
the owner must sffer the penalty of having made an
untimely if not an unwise investment.
It seems hardly necessary to add that the national
and state policy should be to grant liberal terms, and
even to assure a bonus in special cases, to those who
in proper manner and on a scale commensurate with
physical conditions and with industrial and other
requirements will enter upon the development and
marketing of the energy in the flowing stream. The
wise policy would be to grant terms which will assure
a fair profit, but under which, after a reasonable time,
preferably about 50 years, which is a short period in
national and state life, the control of the water
power and the power plant itself with all acces-
sories, at a fair price for physical elements, will
108 PUBLIC UTILITY RATE FIXING
revert to the government, so that then, if it appears
desirable, new terms of use can be agreed upon. By
such a liberal policy the early development of water
powers will be assured and the utilization of energy
which nature annually replenishes will help to con-
serve that which must otherwise be obtained by the
inefficient consumption of a limited store of oil and
coal.
The Life of the Right Affects Its Value
The water right as thus far discussed applies
particularly to the right to put water to a continuing
beneficial use without limit as to the time during
which such right may be exercised. There will be
cases of reversion of the right within a fixed time to
the people who have made the grant thereof and there
will be other cases in which a superior supply of water,
later to be developed, may at some time throw the
original source out of use altogether or leave it avail-
able for only inferior uses. Where a water right thus
or otherwise limited in its life is to be valued, the
question not only arises as to whether it has strategic
value, but also what effect time will have upon the
value.
Earnings Create Value
The value of any water right in excess of its cost,
like the value of a franchise, results as already stated,
from earnings in excess of ordinary interest on the
investment. This value is, therefore, directly depend-
ent upon the rates established by the rate fixing
bodies, or in the case of operation under a franchise,
upon the rates limited by the terms thereof and lim-
ited by the further requirement that they must not
exceed 'what the traffic will bear.' Large power is in
the hands of the rate fixing authorities to make or to
destroy the value of water at its source and until a
definite policy has been adopted by such authorities,
there will continue to be more or less uncertainty
relating to such value. The real value of property of
this character will, for the present, remain somewhat
speculative, particularly in cases where the develop-
ment of the water or of a water power lies in an uncer-
THE VALUE OF A WATER RIGHT 109
tain future. This can hardly be otherwise because it
is not yet certain that the tendency of today to allow
something when value is made the rate-base for the
water right in addition to cost will be adhered to.
When it is generally understood that such an allow-
ance, practically as compensation for making the
development, will be made and when the amount
thereof to be expected under ordinary circumstances
can be approximated, the valuation experts will be
relieved of much embarrassment.
In the case of the established utility, much of the
difficulty ordinarily encountered when water rights
or franchises are to be valued will fall away if the
method of procedure in fixing rates which the writer
recommends be followed and the invested capital and
not present value be made the rate-base.
The San Francisco Rate Case
Since the above notes on the value of water rights
were written the report of the Standing Master in
Chancery, Mr. II. M. Wright, in the case of the
Spring Valley Water Company vs. City and County
of San Francisco (rate case) has been filed with the
court (Oct. 17, 1917) and merits notice. The Master
says on the subject of valuing water rights:
"The valuation of the plaintiff's water rights is con-
sidered by counsel for both parties the most difficult single
subject in this litigation. * * * There is little or nothing
in the way of decided cases to afford a guide to the prin-
ciples of such a valuation."
In speaking of the value assigned to a right of
property, additional to that of the land and structures
which its exercise requires where it cost nothing as
a historical fact, the Master says:
"Such is, in essence, and often in fact, the right to
appropriate water. I have been especially struck with this
peculiarity of this right of property because I have never
seen anything like it among the various rights of property
or elements of value that usually enter into the properties
of a public utility subject to appraisal. Usually the elements
of value have bef>n the result of expenditure, and would cost
money to reproduce; or, if they cost nothing as by gift or
adverse user, would be the subject of estimated cost in the
110 PUBLIC UTILITY RATE FIXING
reproductive method. Here in any view, the right arises by
the act of diversion. Like the miner's right, it is a valuable
right conferred by the United States, and in the case of
water by the State also, to him who finds and takes. And
just as the miner has in his mining claim, after discovery
and location, a property which may possess value in exchange
far beyond his expenditure of labor and money thereon, so
the appropriator has in his right of diversion, a right sep-
arate from his rights in lands and structures, and which
may in a given case have a sale value far beyond his ex-
pended costs. And in the normal case, the value upon which
rates can be earned is the exchange value in the market."
The doctrine of riparian rights was established in
California as a rule of law when the State Legislature
in 1850 declared that :
"The common law of England, so far as it is not repug-
nant to or inconsistent with the Constitution of the United
States, or the Constitution or laws of the State of California
shall be the rule of decision in all the Courts of this State."
Referring to this fact the Master says :
"It may be doubted whether by intention of the legis-
lators of that early day, or by the language employed, the
riparian law was established along with the antithetic exist-
ing water system of appropriation. We need not follow the
history of this question as to the existence of the riparian
rule in this state through the years; it was established as
the law in the common law form of statement, by a divided
court in the great case of Lux vs. Haggin (69 Cal. 255)
decided in 1886."
The Master then calls attention to the fact that
in certain substantial respects the application of the
riparian doctrine has undergone extension and modi-
fication since the Lux v. Haggin case was decided.
It has been extended to apply to underground waters
and as against an appropriator from a stream to the
owner of non-riparian land overlying gravel supplies
fed by that stream. It has been modified so as to
restrict the riparian right to limits defined by actual or
possible beneficial uses upon the riparian land. After
further discussing the rights of the riparian owner the
Master continues :
"I have reviewed the law of this state underlying the
anomalous situation arising from the existence of two rad-
THE VALUE OF A WATER RIGHT 111
ically inconsistent systems of water law as a basis for con-
cluding that in valuing a right founded on appropriation we
will reach correct and consistent results if we disregard all
attempted distinctions drawn from controversies between
riparian proprietors and appi-opriators; in other words,
value the right as if the riparian law had never been in
effect."
Without attempting to follow the reasoning of
the Master at the full length at which presented in the
report, it may be stated that in conformity with the
view held by the courts that fair value must be the
starting point when the sufficiency of earnings is in
question, the Master holds:
"That the fair market value of plaintiff's rights of
diversion, as a whole, during the respective years here in
question, is the proper standard of valuation for rate fixing
purposes; that the extent of the right is to be measured by
the extent of its utilization, that is, the yearly supply to
San Francisco in any year, less the amount derived from
the Pleasanton sources" (underground waters); "that the
Pleasanton supply is properly included by an allowance, in
the capital value, of the market value of the Pleasanton
lands as a whole."
Giving weight to the evidence submitted in this
rate case including the facts in a local recent trans-
action which included the right to 1,000,000 gallons
of water per day and to the findings of Judge E. S.
Farrington in the earlier Spring Valley Water Com-
pany rate case in which a value of about $63,500 per
million gallons of daily delivery was found for 1903,
the Master reaches the conclusion that the unit water
right value to be applied to the actual draft of water
from the various sources of supply in use by the
Spring Valley Water Company was $75,000 per mil-
lion gallons per day in the years 1907-8 and 1908-9;
$80,000 in the years 1909-10'and 1910-11; $85,000 in
the years 1911-12 and 1912-13 and $90,000 in the years
1913-14 and 1014-15. This valuation applies to amounts
of water ranging from 26.5 million gallons per day in
1906-7 to 34 million gallons per day in 1914-15. It
does not apply to from 5 to 7 million gallons of water
per day obtained from the Pleasanton wells whose
112 PUBLIC UTILITY RATE FIXING
value was included by the Master in the market value
of the Pleasanton lands whose ownership was acquired
to secure the water.
Comments Prompted by the Spring Valley Water
Company Rate Case
In the light of the findings of water right values
by the standing Master of Chancery, in the Spring
Valley Water Company rate case, as cited in the pre-
ceding pages, some additional comments on the mar-
ket value of water rights with special application to
conditions near San Francisco and in California gen-
erally may not be out of place.
Comparison with Other Water Rights
The value of water rights elsewhere than near the
Bay of San Francisco is not the measure of the value
of the water rights in use for supplying San Francisco
with water. Nevertheless, the prices actually paid for
water elsewhere in this state and particularly the high-
est prices paid, are elements for consideration in ascer-
taining the market value of water applied, as is the
water of the Spring Valley Water Company, to the
highest use to which water can be applied. The
amount thus paid is an indication of what, under cer-
tain conditions, the person having use for water consid-
ers the same to be worth. This statement applies not
alone to the right to take water at its source but also
to the developed water supply. It is generally true
that when a comparison of general value is made in
any locality, the developed water offers a better basis
of comparison than the right to take water at its
source.
In comparing a water right which is to be valued
with a water right whose value is known, due allow-
ance must be made for all attendant circumstances.
The comparison would be futile if in the one case the
necessity of using the water in question is paramount
while in the other, alternative supplies are available.
The recognized value of undeveloped water,
$1000 to $2000 and more per miner's inch in Southern
E I
THE VALUE OF A WATER RIGHT 113
California for the irrigation of citrus fruits and like
products which yield a good profit to the growers, does
not establish the market value of water rights used for
the same purpose in localities where water is abundant.
Neither is there any close relation between this
value and the value of the right to use water for do-
mestic purposes. Here, too, the question of the avail-
ability of alternative sources of supply is to be consid-
ered and the relative cost of their development, as also
the relation which the amount of water in use and in
future demand bears to the total amount of water
available at the source.
The great difference that usually prevails in the
cost of developing and delivering water generally in
larger amount for irrigation, when compared with the
cost of developing and distributing the water required
in any community for domestic use, makes it difficult
to establish any definite relation betw r een water right
values in the two cases. Even when water, if aban-
doned for domestic use, would be required for irriga-
tion, its secondary value for the latter purpose can not
be made the measure of the market value which it has
by reason of its being required for domestic purposes.
Any water right value which can in such a case be
determined from the highest inferior demand for the
w r ater, as for example, the assumed agricultural use,
is the residual value of the water right. It is that value
upon which a return could be realized if domestic use
were abandoned. It is a lower limit of the value of
the water right.
\Yhen by reason of the growth of a community
new sources of water are added to those already in
use for its supply, the question naturally arises as to
the proper procedure to be adopted in valuing the sev-
eral water rights which are essential to the operation
of the water works system. It is evident that in such
circumstances the water at first in use, by reason of its
proximity, may have strategic advantages, or, which
is quite as likely to be the case, it may. due to danger
of contamination or for other reasons, be subject to
earlv abandonment. The combination of several
114 PUBLIC UTILITY RATE FIXING
sources of supply in one system may be the result of
a combination of two or more developments under sep-
arate ownership, or it may be the result of progressive
development under single ownership. The various
water rights which are thus combined in a single sys-
tem thereby lose, to a large extent at least, their iden-
tity. When the market value of such a combination of
water rights is to be determined, and no good reason
is apparent why they should be treated separately, as
when abandonment of one or the other is prospective,
the w*ater rights of a water works system to the extent
that they are in use, may be considered in the aggre-
gate. This has been done by the Master in this rate
case. In such circumstances, however, the cost or the
sacrifice made in acquiring certain of the water rights
may become an aid in estimating the value of the water
rights in the aggregate.
Mutual Irrigation Water Company Stock Sales as an
Aid in Determining the Value of Water Rights
The selling price of the stock of mutual water
companies which are in business solely for the purpose
of supplying water for irrigation to the lands of the
stockholders, may legitimately be used in determining
the market value of irrigation water rights. In the
case of such organizations it is possible, provided that
all expenditures have been proper and reasonable and
that cost records have been properly kept, or cost of
reproduction can be fairly ascertained, to make a com-
parison between the outlay which may reasonably be
assumed to have been incurred in the installation of
the works which make the delivery of the water to the
stockholder possible and the market value of the water
stock. If this market value, which will, of course, be
affected by the cost of operation, exceeds the cost of
the irrigation system, the difference will represent the
market value of the water right. This is a broad
statement of a general principle. Each separate case
will require special consideration and no individual
transactions can be accepted as conclusive evidence of
the value of a water right in question. By giving con-
THE VALUE OF A WATER RIGHT 115
sideration, however, to a number of mutual water
companies and determining for each, from stock trans-
fers or otherwise, the value of the right to take water
at its source, a fair idea can generally be obtained of
the amount which the irrigator is willing to pay for
water rights. It is more likely, however, that there
will be some approximation to uniformity in the value
of the developed water at the point of delivery when
a number of canals in the same region under the same
soil, climatic and crop conditions, are compared (pro-
vided that there remains under each canal unirrigated
land seeking water), than that there will be anything
like uniformity in the net water right values of the
same canals.
There is no reason apparent, under such circum-
stances, why under the same charges for operation
and the same reliability of service, the water at the
field or place of use should have a value, in the case of
the concern whose investment to secure the water is
small, different from the value which is conceded to
the water at the field from another concern whose
investment to secure the water has been large. The
first of these concerns may show a high net water right
value while the second with water possibly from the
same source shows a low net water right value. Both
concerns may, notwithstanding wide departures from
average values, help to determine the regional value of
the privilege to use water for irrigation. The differ-
ence in the quantity of water in use by two such canals
may make it desirable, however, to assign different
weights to the results thus ascertained if therefrom a
conclusion is to be drawn as to the probable market
value of a third water right. Usually the cost of works
for the delivery of water to the place of use is greatest
per unit of quantity in the case of the concern whose
water output is the smallest. Consequently, when a
water right value is to be determined, there may be
some advantage in weighting any ascertained market
values for separate canal or water works system ac-
cording to the relation which the amount of water sup-
plied by each bears to the quantity covered by the
116 PUBLIC UTILITY RATE FIXING
water right whose value is in question. Results have
been thus weighted for example in testimony submit-
ted to the Master in the Spring Valley Water Com-
pany rate case by Mr. F. C. Herrman in combining the
Livermore sale, the Beckwith-Coult sale, and the
Phillips-Osborn sale of which the first covers 1,000,000
gallons of water per day and the others only 2000 and
1000 gallons per day respectively. He gives the average
cost for the aggregate amount of water. Though this
combination has but little value, because two very
small amounts of water obtainable from springs and
wells for residential use are combined with a relatively
large supply to be utilized for a town supply, never-
theless, it illustrates a method of combination which
may under certain conditions throw additional light
upon the problem of ascertaining water right value.
If a similar procedure had been followed by Mr.
Herrman, Mr. Geo. G. Anderson appearing for the
Water Company and Mr. C. H. Lee appearing for the
City of San Francisco in the discussion of the conclu-
sions drawn from mutual water company stock sales,
cited by them, in the same rate case, some further light
would have been thrown upon the value of water rights
in the regions and under conditions of use as explained
in their testimony. It would certainly be desirable to
know in each case to what amount of water the ascer-
tained water right value applies. It is to be noted that,
as an index of the value of water rights for the highest
use to which water can be put and in localities where
the demand is for the full utilization of all available
water, only those examples need be taken into
account for comparison, in which the water right
values appear relatively high - all others may be
dismissed from consideration. The lists submitted by
Mr. Lee, who appeared for San Francisco, might have
been extended to include many more mutual water
companies operating in regions where water is plen-
tiful or where, due to local conditions, the high market
value, prevailing in other sections of the state, is not
yet realized and by such extension the apparent arith-
metical average values could have been cut down to
THE VALUE OF A WATER RIGHT 117
almost any limit without throwing any new light on
the value of water rights for domestic use at San Fran-
cisco. It follows that such averages can be of but
little benefit as an aid in ascertaining the market value
of water, particularly when value in another section of
the state is in question and the water is required or
is being used for an entirely different purpose. It is
nevertheless proper to give consideration to the high-
est values of irrigation water rights anywhere in Cali-
fornia because it appears clear that, where, as in the
case of the San Francisco Bay region, water is scarce
and is required for domestic use, the market value of
the water right might reasonably be expected to be
higher than elsewhere in the state for irrigation use.
The demand for the utilization of the available sources
of water on both sides of San Francisco Bay, in rela-
tion to their yield, is probably quite as insistent as
anywhere else in the state. Furthermore, the nature
of the demand for water is of a higher order near great
centers of population than in the farming region. As
has been stated in a preceding article, the demand for
domestic use is an imperative demand while for all
other purposes the demand ceases when it is no longer
profitable to use the water. Such considerations as
these would be weighed by a seller or a purchaser
of water rights near San Francisco and would have
more or less effect upon their conclusions relating to
market value even though no direct method can be
found of making the value of water somewhere in
Southern California a standard of value in any other
locality. Water right values elsewhere in this state,
even where water is used for other than domestic
purposes, are not therefore to be ruled out of consid-
eration altogether.
The Enhanced Value of Irrigated Land in Relation
to the Value of Water Rights
Some reference has been made in the evidence
presented in the Spring Valley Water Company rate
case to the enhanced value of land as a means of deter-
mining the value of water rights in communities where
118 PUBLIC UTILITY RATE FIXING
the crop return can be increased by irrrigation. It is
difficult to establish the relation between these two
elements. When the farmer has made an investment
to secure water and finds that the increase in the net
crop output of his farm is greater than the annual cost
of the water, including interest on this investment, he
can form some opinion of the value which the use of
water has added to the farm. If the capitalized in-
crease of crop output exceeds his investment for water,
he has made a profit and this profit can be used as a
basis for approximating the net worth to him of the
water right.
The net water right value from the standpoint of
the irrigator is the capitalization of profit resulting
from the use of water in excess of interest on the
amount which he has invested in securing it. While
this net value may be but small, the gross value of the
water, or what the irrigator would expect to get if he
parted with the right to use it and no alternative sup-
ply were available to him, would be this capitalized
profit plus his investment in the water.
The question may well be asked when water is
taken for a higher use, how the sacrifice of the land-
owner who has a water right which can be utilized
for irrigation, but which has never been put to use,
compares with the sacrifice which another landowner
makes who has actually put the water to use on his
land. In the case of the second landowner it may be
that the profit resulting from the use of the water is
not large. If it were otherwise, the first landowner
would probably not have allowed his water to remain
unused. Assuming that there is some definitely ascer-
tainable profit, however, then this prospective profit,
suitably discounted, can be made the measure of the
sacrifice which the first owner would make if he gives
up his water right, and, as already stated, this profit
plus the cost of the second landowner's plant would
measure the second landowner's sacrifice. Neither the
former nor the latter sacrifice, both possibly represent-
ing payments for water rights, taken singly, represent
the market value of water rights and yet both such
THE VALUE OF A WATER RIGHT 119
determinations of value may deserve consideration
when the market value of water rights involving the
abandonment of established or prospective uses of the
water, is to be determined.
The Obligation to Supply Water at Less than Cost
The demonstration to show that the sacrifice made
in delivering water at less than cost in return for a
water right is to be taken into account in the same
way as cash expended, can be made as follows :
Assume that in order to secure a water supply of
1,000,000 gallons per day from a certain creek, it is
necessary to furnish free of cost a second million gal-
lons per day to the original owner of the creek water
right. Let it be assumed that it costs $200,000 to make
the development and that the annual cost of operation,
exclusive of interest, is $10,000. If the cost of develop-
ing only 1,000,000 gallons per day would have been
$150,000 and the cost of operation $7,500, then the
water right represents a sacrifice made by the owner:
In capital invested ($200,000 150,000= $50,000
In operating expenses (10,000 7500)
= $2500 capitalized at 6% 41,700
Total, $91,700
In order to meet this sacrifice, with only a bare
interest return on the investment, the earnings on the
sale of 1,000,000 gallons of water per day should be:
Interest at 6<7r =$12,000
Operating expenses = 10,000 $22,000
If there had been no sacrifice to secure the water
right then the necessary earnings would have been :
Interest at 67r = $9,000
Operating expenses = 7,500 $16,500
The difference between $22,000 and $16,500, cap-
italized at () c /c is again $91,700. The rate-pavers are
required to contribute a return on the sacrifice which
is made to secure the water which they get, just as
though this sacrifice had been represented by a cash
investment.
120 PUBLIC UTILITY RATE FIXING
If there were two concerns in operation, the one
subject to the water burden and the other also supply-
ing 1,000,000 gallons of water per day, and at the same
rates, but not subject to a water burden, the advantage
in favor of the latter would be estimated as follows :
Smaller operating expenses by $2500
Interest at 6% on $50,000 smaller investment =. 3000
Total advantage in net revenue
This, when capitalized, represents the excess of
value over the capital invested. At 6% interest this
excess amounts to $91,670. This represents the advan-
tage which the concern operating without the water
burden would have over the other. It is equal to what
it cost the other concern to secure its water rights.
The necessity of using the water of both concerns has,
of course, been assumed. When the market value of
water rights is in question the obligation which 'has
been assumed to furnish water free or at less than cost
to the former owners of adverse rights can thus be
made an aid in solving the problem.
All that has been said about market value is, of
course, apart from the other fundamental question
relating to whether or not market values should appear
in the rate case. This question has elsewhere in these
articles received full consideration.
THE RATE OF RETURN 121
CHAPTER VII
THE RATE OF RETURN
Protection of the Investment
The business of every public service concern is
subject to regulation and control by properly consti-
tuted authority. It will not be going too far to say that
any business which is monopolistic in character should
be considered subject, at the will of the public, to like
regulation and control, even though there are as yet,
only the first symptoms apparent that there may in
time be a full exercise of the public's right in this dir-
ection. But whenever the public controls and regu-
lates a business, particlarly in the matter of fixing the
price of the output, it is fundamental that any legiti-
mate investment made for the benefit of the public
must be adequately protected. Whatever sacrifice the
owner of a public utility makes should be of a tem-
porary character only. He should never be compelled
to operate under conditions that leave the question of
protection of his legitimate investment in doubt.
Whenever this protection is not assured, the element
of risk grows as a factor to be considered, and in some
way or other the public must meet the resultant
higher cost of the commodity or service. The time
has not yet come when the public is willing to go so
far as to guarantee to the owner of the public utility
full protection against loss ; but there are those who
believe that it might be wise to extend such full pro-
tection, at least in the case of some of the more im-
portant public utilities. That this would in no small
measure simplify the matter of rate fixing is selt-
evident. Meanwhile the rate of return to which the
public utility owner is fairly entitled must be con-
sidered to be affected more or less by risk.
The fundamental requirement when the earnings
of a public utility are to be limited, is, therefore, as
has been stated, that they be adequate to afford pro-
122 PUBLIC UTILITY RATE FIXING
tection to the investment. But the owner of a public
utility is entitled, by right, to something more than
a mere protection of investment. He, by reason of his
experience and the credit which he and his associates
and backers command, makes it possible for the com-
munity to enjoy the advantages of transportation, of
adequate water supply, of telephone and telegraph fa-
cilities, of lighting and heating opportunities, which
without his help, might have to be long deferred. The
establishment of the public utility, due to his enter-
prise, immediately adds value to the land holdings and
other property within the area served and in lesser
degree, also to surrounding lands and property within
the broader zone in which the property values are in
any way affected by the growth of the community
which is served by the utility. The owner of the
public utility is therefore, a public benefactor and
should be compensated not merely as an agent of- the
public would be compensated, but he should also get
some reward for adding to the unearned increment of
other property owners. He may in some instances
profit as owner of appreciating property such as real
estate, but in other instances full compensation should
be otherwise arranged for, as for example, by allowing
him to share in the general prosperity to which his
financial resources have contributed.
How this compensation should be made, what its
amount should be, and what factors should be taken
into consideration when rates are to be fixed has been
discussed in the previous articles of this series. It
has been pointed out that to protect the investment
adequately and fairly, a proper determination of this
investment should be made and that undiminished by
depreciation this investment will be the "natural rate
base." It has also been pointed out that the compen-
sation for management, hazard and participation in
general prosperity can be more satisfactorily brought
into relation with the volume of business than into
relation with any rate base. There remain to be con-
sidered what the fair rate of return should be when
viewed from various standpoints.
THE RATE OF RETURN 123
In the case of any "going concern" which is so
firmly established that indefinite life and certainty of
continuous earning capacity may be assumed, the
business world recognizes as adequate some generally
acceptable rate of return on the capital legitimately
invested in the enterprise, supplemented by what may
be called profit, which ordinarily will be considered
in its relation to the volume of business.
If the amount by which the dependable annual
gross earnings exceed the operating expenses (the
latter being here taken exclusive of interest on the
invested capital) be capitalized at an interest rate,
based on an acceptable rate of return as above defined,
the aggregate value of the enterprise will be found.
This will cover, in the case of the successful property,
not alone the value of physical elements and the
amounts actually expended for rights, privileges and
easements but also the other elements of intangible
value such as good will, going value, water rights,
concessions, patents and the like.
Other Factors Besides the Rate of Return on the
Legitimate Investment
It is an interesting study to determine for any
class of enterprise, be they of a private character or
in the public service class, what should be considered
a fair rate of return on an investment adequate to
establish an enterprise of the class in question and
what would be a reasonable profit in excess of the
earnings that would otherwise just cover this rate of
return.
Unfortunately there has no attempt been made
heretofore to thus subdivide the gross profits of public
service concerns. It has seemed sufficient to say that
a return of 7 or 8 or 9 per cent per annum as the case
may be, computed on the value of the property, is a
fair return. The value which is created by the net
earnings is quite illogically made the base to be used
in determining what the rate of return is.
How much better would it be to make the separa-
tion, which will certainly appeal to the business man,
124 PUBLIC UTILITY RATE FIXING
as above indicated into interest on the capital in the
business venture and profit expressed in relation to
the volume of business.
When as in the case of water-works the amount
of capital invested is ordinarily large in comparison
with the annual income (volume of business), not in-
frequently 10 to 1, the defects of the ordinary proced-
ure are not so striking as in the case of the concern
which does a large annual business on a small invest-
ment. In the latter case the cost of money to the
owners for use in the enterprise may be no greater
than in the former and yet, if there were no return in
excess of what would be a fair return on relatively
large capital investments, the enterprise would not be
undertaken.
There is, therefore, no standard fair rate of re-
turn that can be prescribed or that will prove accept-
able unless the same be applied to investment and be
supplemented with a profit which as stated should bear
some relation to the annual volume of business.
But even when thus separated into two parts, the
net earnings which should be considered adequate by
a prudent business man are not determinable by any
fixed standard. This is particularly true of the profit
item when taken apart from and as an addition to
interest on the capital reasonably and properly in-
vested. This profit item will naturally fluctuate with
the degree of risk and with the public's estimate of
general prosperity, and with the value that may attach
to business skill, integrity and responsibility involved
in providing the plant and the business organization
and directing its operation.
If money at interest in savings banks or invested
in municipal or government securities regarded as
safe brings an interest return of 4^ per annum, the
money placed in industrial enterprises or into estab-
lished and demonstrated public utilities should bring
a return of at least 5 or 6 per cent. A fair return
would be 6 or 7% provided, of course, that this return
is free from the hazards of the business and from the
THE RATE OF RETURN 125
responsibility of management. When an enterprise is
in sucessful operation the owner thereof would expect
to get money when he needs it at these rates and the
lender would want not less than such a return because
he, too, makes some sacrifice whenever he accepts
paper, which may not be readily negotiable in the
financial market. This being the situation, the owner,
himself, expects and is entitled to some such a return
on the money sacrifice which he has made to establish
the business, or, if viewed from a slightly different
standpoint, which he or any one else would have to
make to reproduce and reestablish the business if the
same were non-existent. But he would still be inad-
equately compensated if there were not some addi-
tional return in sight as already explained.
The rate fixing authorities have made it a prac-
tice, however undesirable this may be, of allowing
certain rates of return on the value of the public serv-
ice properties. There is, in this practice, a disregard
of the elements which deserve special consideration.
Thus for example, the owner of gas works or of a plant
for supplying electric energy may be allowed, by rate
fixing authorities to earn 8% or a little more on the
so-called fair value of his property, while if he is in
the business of supplying water for domestic use he
may be held down to 6 or 7%.
Rate of Return Defined
When the question is asked What is a fair rate
of return?- the first point to be determined will be
the base to which this rate is to apply. This base may
be either the investment, i. e., the natural rate base,
or, as many would have it, the value of the property in
question. The question, therefore, should be modified.
It may be put in cither of the following two forms:
1. What is a fair rate of retuz-n on the value of the
property?
2. What is a fair rate of return on the capital legiti-
mately invested in the enterprise not diminished by
depreciation (on the natural rate base) ?
While the first of these questions is apparently
illogical because value results from earnings, it never-
126 PUBLIC UTILITY RATE FIXING
theless deserves consideration. The owner as well as
the rate-payer is interested in knowing whether the
business falls into the class of enterprises in which net
earnings may be capitalized at such low percentages
as 5 or 6 or whether capitalization should be at higher
rates. This is convenient and valuable information
but in the matter of rate fixing leads nowhere until
the limit to be placed on earnings has been otherwise
determined. The interest rate of capitalization will
vary according to the nature and the magnitude of the
enterprise. It will, when ascertained, be applied to
the net earnings which should include allowances for
risk, for management, and for a share in general pros-
perity. This interest rate is not to be confounded with
the rate of return on the investment, which in the
case of the successful business will always be a higher
rate, because in the successful business the investment
is less than value.
The question in its second form will be vital so
long as the rate base alone, without regard to volume
of business, is taken into account, because upon the
correct answer depends, not alone the protection of the
owner's investment in the enterprise, but also the de-
gree of encouragement to be given to others to place
their financial resources at the disposal of the public
by engaging in similar ventures.
Strictly speaking, therefore, and considered from
the standpoint of the owner, the rate of return would
be the amount per hundred, or the amount on some
other unit, of the net earnings in relation to the cap-
ital which has actually been invested or which in the
judgment of the public should be assumed to have
been invested in the enterprise. The net earnings in
the sense here used represent the excess of the income
over operating expenses, the latter expression being
used in its broadest sense, including a proper allow-
ance for replacements. In the successful venture the
rate of return will be such that the investment of cap-
ital therein will appear attractive. When the enter-
prise has been long established, well managed and is
non-competitive, this rate may be relatively low with-
THE RATE OF RETURN 127
out mitigating against the successful operation thereof,
while, in the case of a new venture, the rate of return,
immediate or prospective or both immediate and pros-
pective, should be relatively high in order that the in-
vestment of capital may be encouraged and not re-
pelled.
The Obligation of the Public When It Regulates
The public has the right, now hardly questioned,
to regulate rates, and thereby to limit the rate of re-
turn of the public utility. It has already been stated
that the extension of this power of regulation to the
affairs of persons and corporations whose business has
grown to such proportions that they can crush their
smaller competitors, is fast coming to be recognized as
desirable. But when this power is exercised whether
over the public utility, or over trusts and corporations
of monopolistic tendencies, the question may be asked,
as already intimated, whether or not the limitation of
earnings should not be accompanied by some measure
of guarantee that there will be adequate earnings,
either for a definite period of time, or for time without
limit. Probably no one has yet gone quite so far as
to hold that it would be fundamentally sound when
rates are regulated by public authority to guarantee a
lower limit of net earnings ; and yet this is the logical
outcome of regulation. If such a practice could obtain
the true agency relation would be established. The
utility owner would then, in fact, be the agent of the
community which the utility serves, and therefore
entitled to nothing for risk, nor for unearned incre-
ment, but only to the ordinary return on safe invest-
ment plus compensations for management. The latter
in such a case might be reasonably placed at 2 to 5
per cent of the volume of business according to
whether this volume is large or small. This does not
mean that a guaranteed rate of return could be made
the same in all parts of the country and for all utili-
ties. There would always be considerable range in
the degree of security afforded by government or
municipal guarantees of rates of return and then, too,
the rates of return on safe investments are not everv-
128 PUBLIC UTILITY RATE FIXING
where and under all circumstances the same. It might
also make a difference whether an enterprise is already
profitable or whether it depends for profit on future
earnings; whether it is certain to be ultimately suc-
cessful or whether there remains a doubt concerning
the wisdom of having afforded to it the government
or community backing. And then the question will
arise, whether efficient service can be hoped for if the
element of risk is entirely removed. Would not this
lead to carelessness and indifference to the disadvan-
tage of the public?
Regulation then should not go too far, the limit of
earnings should not be too definitely defined ; there
should remain the possibility of increasing profits by
efficient management.
Rate of Return Illustrations
How the rate of return will vary according to the
rate base to which applied can perhaps be shown to
advantage by examples.
Let it be supposed that the business of a utility
is under consideration to which the following facts
apply :
Investment (determined from cost and from the
estimated reproduction cost) $1,000,000
Accrued depreciation _ 200,000
Investment less accrued depreciation 800,000
Past amortization of capital uncertain
Operating expenses (including the current re-
placement requirement) 250,000
Gross annual income 350,000
Net annual income 100,000
Rate of return applied to value as it would be
found if all properties were new 8%
Capitalization of net income, 100,000 at8% 1,250,000
Present value, 1,250,000 200,000 1,050,000
Going value, 1,050,000 800,000 250,000
The 'going value' as here listed is the excess of
the value of the 'going concern' $1,050,000 over the
original investment less depreciation $800,000. If the
enterprise were new the comparison would be with
another in exactly the same condition ready to begin
business but not yet in operation and the same result
THE RATE OF RETURN 129
would be found. Going value is, therefore, independ-
ent of accrued depreciation.
If money, borrowed for investment on this enter-
prise can be had at 6% interest, the owners will be get-
ting 8% 6% =2% on the original investment for
management, risk, etc. which is $20,000.
When, for such a concern, rates are to be fixed,
the gross income, the net income and the value are all
unknown quantities. The procedure should then be
about as follows :
Required earnings:
8% on the original investment of $1,000,000 80,000
Operating expenses $250,000
Allowance for management about 2.5% and
and for risk and profit about 3% of the
volume of business, say 20,000
Total required earnings $350,000
The allowance here noted of $20,000 for manage-
ment, risk and profit capitalized at S% is $250,000.
This will be the 'going value' of the business created
by such earnings.
The natural rate base in this illustration is $1,000,-
000, representing investment not diminished by depre-
ciation. If the net return be compared with this rate
base, the rate of return is found to be 10%. In fixing
rates, it is undesirable to use this relation because
there is included therein, profit and compensation for
management and an allowance for risk which as ex-
plained should be brought into relation to volume of
business. It may be repeated that such comparison
with volume of business is preferable to a possible
alternative, a comparison with the cost of operation,
for the same reason that the merchant desires to ex-
press the profit in his sales in percentage of his re-
ceipts, rather than in relation to cost. This is no doubt
due to the fact that the sale price is more stable and
subject to less fluctuation than cost.
As a second illustration, let it be supposed that
the following facts relating to a steamboat business
have been ascertained :
130 PUBLIC UTILITY RATE FIXING
The steamboat cost new and can be replaced for $500,000
Its present value is appraised at 100,000
There are invested in other items connected with
the business, lands, buildings, wharves, etc.
original cost 500,000
The present value of these other items is 300,000
The mean annual dependable gross receipts are 450,000
The operating expenses per annum including a fair
replacement increment, are 250,000
The net return, therefore 200,000
The rate of return on the value of this business
as value would be found if all properties were
new, should be, per annum 15%
What is the value of the business?
What is the value of the good-will? or in case of
a public utility and no competition, what is the
'going value?'
If the steamboat were new the value of the busi-
ness would be found by capitalizing the net earnings
($450,000 $250,000= ) $200,000 at 15 per cent This
would make the business worth $1,330,000. But as
there remains only $100,000 of the original value of the
steamboat to be made good before the steamboat will
have to be replaced and this is $400,000 short of the
cost of a new steamboat, and because the other prop-
erties connected with the business have decreased in
value $200,000 (supposed in this case to have been
covered by past earnings) the present value of the
business will fall ($400,000 -f $200,000= ) $600,000
short of the value that would obtain if all the proper-
ties including the steamboat were new. Consequently
the value of the property is $1,330,000 $600,000 =
$730,000.
Purchased at this price the new owner would ap-
parently be earning $200,000 annually on an invest-
ment of $730,000. His rate of return would appear to
be 27.4 per cent on this investment. But he has
assumed an obligation to re-invest in a new steamboat
when the old one fails at which time he will have
earned only $100,000 toward the cost of this steam-
boat. He has also assumed the obligation to keep in
repair and at full efficiency, buildings and wharves
which arc no longer new and whose up-keep will cost
more than if they were all new. He will have assumed
all the obligations that went with the original invest-
THE RATE OF RETURN 131
ment of $1,000,000 and can not afford to pay more
than the $730,000 for the business without consenting
to a rate of return on such investments less than the
assumed $15% rate.
The 'good-will' or 'going value' of the business as
the case may be, is found by comparing the invest-
ment in the business with the value thereof, all prop-
erties being assumed new (or by comparing present
value with the investment decreased by accrued depre-
ciation). In this case it will be $1,330,000 $1,000,000
= $330,000, or $730,000 $400,000 = $330,000.
If now it is possible to borrow money for invest-
ment in this steamboat enterprise at a cost of 7% per
annum and, for the purpose of illustration, it be
assumed that the entire original investment of $1,000,-
000 has been thus borrowed, the owner would have to
pay out as interest $70,000 leaving $200,000 $70,000 =
$130,000 as his compensation for management, as-
sumption of hazard, and share in general prosperity.
This is equivalent to about 30% on the volume of
business. This rate is high because the volume of
business which has been assumed is small. It should
be relatively high because the steamboat business is
hazardous.
The rate of return based on the present value is
found by comparing the net income of $200,000 with
the present value $730,000. It is 27.4%.
What in the case of this steamboat business is
the rate of return expressed in relation to the original
investment?
The original investment was $1,000,000. This is
made up of the value of the physical properties
$400,000 plus the obligation to make good the accrued
depreciation of $600,000 as required. The net income
is $200,000. The rate of return on the original invest-
ment, on the natural rate base, is therefore, 20 per cent
per annum.
\Yhat in the case of the same property is the rate
of return expressed in relation to the investment de-
creased by accrued depreciation i. e., relative to the
132 PUBLIC UTILITY RATE FIXING
so-called depreciated or present value without inclu-
sion of going value?
As the original investment was $1,000,000 and the
accrued depreciation is $600,000 the present value, ex-
clusive of 'going value' is $400,000 and the rate of
return on this basis 50% per annum.
These illustrations make plain the proposition that
the rate of return varies according to the base to which
applied without affecting the essential element, the net
earnings.
The Spring Valley Water Co. Rate Case
On the subject of the fair rate of return in the
Spring Valley Water Company rate case,* the stand-
ing Master in Chancery, Mr. H. M. Wright, in his
report filed with the court in October, 1917, says:
"What we desire to determine is the fair rate of return
which the capital already invested and in fixed form in plain-
tiff's properties was entitled to earn in the different years in
question as a reward for its dedication to the public service.
The usual test for determining that fair rate is, what rate
of return would in any such year attract new capital to an
investment in plaintiff's property to provide additions or
extensions thereto. I presume the theory is that the existing
investor should receive at any time for the use of his capital
already in the enterprise whatever a new investor would de-
mand in return for new capital put in alongside the existing
capital, or, otherwise expressed, the current market rate of
money for this purpose. The point of view seems to me cor-
rect and helpful and if I mistake not is acceded to by counsel
for both parties."
"It is the plaintiff's position that a showing of less than
7% per annum net return is less than a reasonable rate. It is
the city's position that 5% is 'non-confiscatory' or, in other
words, reasonable; it is not in terms conceded that less than
5% is unreasonable."
In the case of Willcox vs. Consolidated Gas Co.
(212 U. S. 19) the U. S. Supreme Court says in refer-
ring to factors which influence the rate of return:
"The amount of risk in the business is a most important
factor, as well as the locality where the business is conducted,
and the rate expected and usually realized thereupon, invest-
ments of a somewhat similar nature with regard to the risk
attending them. * * * The less risk, the less right to any
unusual returns upon the investments."
After stating that in the case of the Consolidated
Gas Company the risk was "reduced almost to a min-
*Spring Valley Water Go. vs. San Francisco (rate case).
THE RATE OF RETURN 133
imum, because future competition was 'unthinkable' "
and that its business was "the most favorably situated
gas business in America," the Court says:
"Taking all facts into consideration, we concur with
the court below on this question, and think complainant is
entitled to 6% on the fair value of its property devoted to
the public use."
The Master in the Spring Valley Water Company
rate case, after stating that this rate of return applies
to New York in 1906, reaches the conclusion that
under the different circumstances, particularly as to
the risks involved and the difference in the money
markets and rates of New York and San Francisco,
"a higher rate would be proper for this plaintiff in
1907-15" if 6% was a proper rate for the Consolidated
Gas Company in New York in 1906. The Master then
reviews earlier decisions in water rate cases in Cali-
fornia showing rates of return heretofore allowed and
also the rates of return on real estate loans and on
stocks and bonds, and cites the testimony of expert
witnesses and reaches the conclusion :
"That the fair rate of return, net, which plaintiff was
entitled to earn during the period 1907 to 1915 inclusive, for
the service of '(supplying)' water to San Francisco and its
people, was seven per cent per annum upon the property val-
ues as found in this report. And if the court shall conclude
that a sum for going value should not be included in the
appraisal of capital in use, so that the works is valued prac-
tically as a new enterprise, then I find the fair rate to be
applied was eight per cent."
The Master in reaching this conclusion follows
the usual practice of bringing the entire net earnings
into a percentage relation to the property values in-
stead of making a subdivision thereof, as the writer
points out would be more logical. The result would
be practically the same, for example, in the case of a
public utility valued at $30,000,000, whose operating
expenses are $1,200,000 per annum when earnings are
to be limited, whether the net income be computed at
6 c /c on $30,000,000, plus an allowance of lO^r on the
gross income of about $3,300.000 amounting to
($1,800,000 + $330,000=) $2,130,000, or whether the
same be computed at a 7 c /c rate of return amounting
to $2,100,000. The desirability of the first of these
134 PUBLIC UTILITY RATE FIXING
methods of determining the net income to be allowed,
under which some regard is had to the volume of
business as well as to the natural rate base, has been
fully discussed in a preceding article of this series.
In the District Court of the United States for the
Northern District of California the findings of the
Master in reference to the rate of return, as above
quoted, did not receive unqualified approval. The
Court holds that while 7 per cent may be accepted as
a fair rate of return the lower rate of 6 per cent would
not be confiscatory. Judge Franklin H. Rudkin, who
issued the decree of the Court, says in this connection :
"The Master found that the plaintiff was entitled
to a return of seven per cent on its invested capital
during the several years in controversy here. If this
is to be deemed a mere finding that such a rate of
return was fair and reasonable as between the com-
pany and the water consumers, I have no comment or
criticism to make. If, on the other hand, it is to be
deemed a finding or conclusion that any less rate of
return was confiscatory and violative of the Constitu-
tion of the United States, I must dissent therefrom."
"I am of opinion that a return of as high as
six per cent on the invested capital or value of prop-
erty devoted to the service of the public, is not confis-
catory and violates no constitutional right of the plain-
tiff.""
While it appears from this quotation that the
Court does not make a clear distinction between "in-
vested capital'' and "value of property" other portions
of the Court's opinion show that application of the
rate of return to the value of the property is intended.
THE RATE CHEDULE 135
CHAPTER VIII
THE RATE SCHEDULE
Unit Price to Consumers Not Uniform
In these articles on rate fixing- there has thus far
nothing been said about the distribution to the indi-
vidual rate payers of the aggregate charge for service
rendered or for commodity furnished by a public
utility. The custom has become established of making
the collections from the rate payers practically the
sole source of revenue. The charges are usually so
adjusted when applied to the individual rate payer
that they are brought into relation, approximately at
least to the cost of rendering the individual service.
Equalization of the unit price to all consumers can not
be hoped for. In any group of consumers who pay
exactly the same amount for equal amounts of service
the actual cost of rendering the service to the individ-
ual consumer may vary within wide limits. The rate
is fixed on the average cost of the particular service
to a large number of individuals. Absolute equaliza-
tion of the relation of the rate to the cost of service
in each separate case is also out of the question.
Generally, however, the greater the range in this cost
the more varied will the rates be and the stronger the
tendency to adjust the charge to what it costs to serve
each individual. Then again, at equal amounts of
commodity furnished the nature of the service may
vary greatly, as for example in the case of the delivery
of electric energy to operate motors. Preparation must
be made in such a case to supply the maximum
amount of electric current that may at any time be
demanded by the consumer and yet the consumer may
operate his plant at only a small fraction of its in-
stalled capacity. In such event a charge is made for
being ready to serve. The preparation to serve is an
element of cost and expense to the utility which.
136 PUBLIC UTILITY RATE FIXING
because it is independent of the amount of service,
tends to make the unit cost of the service to individual
consumers unequal.
Such items as reading meters, billing and collect-
ing do not change materially with the amount of serv-
ice called for by the individual consumer. Because
they are relatively large in the case of the small con-
sumer they add materially to the cost of serving him.
They add but little, on the other hand, to the unit
cost of service in the case of the large consumer. It is
natural, therefore, to find the unit price at which the
small consumer pays for what he gets much higher
than that at which the large consumer is served.
Some Problems for Consideration
The universal willingness of the rate payers to
pay for what they get and the recognition of such
facts as these has reconciled the small consumer to. the
larger proportional payment which he makes. Fur-
thermore, because he is a small consumer the amount
involved in each monthly payment is small and there
is no complaint. All the more reason, therefore, why
the rate fixing authorities should guard the small con-
sumer against any inequitable distribution of the
charges for service rendered.
It is not proposed to enter into a minute exposi-
tion of the principles which should control in fixing
the rates for each type of public service. These are
only random comments on problems which have
already provoked much discussion. Thus for example,
certain water works managements are endeavoring to
secure application of the principle that they should
be compensated for being ready to serve as in the case
of the unoccupied house which is connected with their
mains but is using no water. The question is how
far to carry the ready-to-serve idea. Readiness to
serve may have considerable relative value as is true
of the telephone or of the installation necessary to
supply electric energy to a fire pump. Again it may
mean very little, as in the case of the gas or water
main which has a capacity to serve the prospective
THE RATE SCHEDULE 137
consumers during the next quarter of a century.
Another problem relates to the distribution of the
aggregate amount to be collected from rate payers to
classes or groups into which they can be divided on
the basis of the aggregate costs of rendering the serv-
ice to the consumers in each group.
How, for example, shall the charges for upkeep
and operation, including interest on the invested cap-
ital, be allocated in the case of an irrigation system
which, by gravity flow, covers certain lands located
near the source of supply, other lands remote from
this source and also serves others to which water is
pumped? Let it be supposed that the situation is
such that cooperation of all of the several sub-sections
of the area served by the system is essential to make
the project economically feasible. If, in these circum-
stances it is proper to restrict the burden on each of
the subdivisions as here named to an interest in only
that part of the system which is essential to secure
to it a delivery of water, then why should not the
same principle apply to each separate tract in each of
the several subdivisions? This seems plausible and
has in one or two cases been tried, as for example
on one of the older canals diverting water from Tule
river in California. The land owners, in this case, con-
structed the canal as a mutual enterprise, agreeing
among themselves that only the construction cost and
operating expenses down to the point where the main
canal reaches the lands of the respective participants,
should come into consideration in estimating the
charges to be placed against each. They overlooked
the fact, and this fact is generally overlooked, that the
construction of the canal added value to their holdings.
Let it be supposed that this increase of value was the
same acre for acre near the head of the canal as at its
lower end. If this increase, for purposes of illustration,
be placed at $100 per acre and the cost of the canal
was $20 per acre for the land owner nearest the head
of the canal and $60 for the one at its lower end, then
the unearned increment realized by the former was
$80 as against only $40 by the latter. The apportion-
138 PUBLIC UTILITY RATE FIXING
ment of construction cost on this basis was not as fair
as it appeared to be. Operating expenses, in such cir-
cumstances, can, with much greater propriety, be ad-
justed according to the location of the land served
with water, thereby giving to each tract the advan-
tages to which its location and other natural condi-
tions may entitle it. In practice, however, it is gener-
ally found advisable to make no such distinction unless
peculiar circumstances make the same desirable as
would be the case if from an irrigation system, orig-
inally constructed as a gravity system, water were
pumped to higher lands. These lands being less favor-
ably circumstanced than those covered by the gravity
system should, in equity bear the additional burden
resulting from the installation and operation of the
pumps.
The Unearned Increment as a Factor
That the construction of an irrigation system may
add materially to the value of the land to which it
supplies water is obvious and frequently this incre-
ment of value is at once apparent. The unearned
increment of value which results from the installation
of a telegraph or telephone system, or the establish-
ment of an express service, or from the construction
of a street car line or a gas or water works is often
uncertain, not easily recognized and usually impossible
to express in definite figures. Furthermore, the pros-
pective realization of the advantages which will result
from the establishment of public utilities is frequently
the cause of high market value of real estate. It is
hardly necessary to say that the inflation of these
values in anticipation of future improvements is some-
times not warranted by the circumstances. The fact
remains, however, that the readiness and even the
prospective readiness of each type of utility to serve
any community does add some increment of value to
the property in that community. The establishment of
each utility adds to the general prosperity. The readi-
ness to serve, considered in its broadest sense in other
words, affects the entire community even as the water
and the gas main on any particular street affects prop-
THE RATE SCHEDULE 139
erty values on that street, and as more obviously any
expense incurred to serve a particular tract of land
with any necessary service or commodity adds value
to that tract.
Determining Factors
In fixing the rates at which the individual con-
sumer is to be charged for a commodity furnished by
a public utility or for a service rendered, there must
of course first be a determination of the aggregate
amount to be realized from an application of these
rates. In fixing the items of the rate schedule consid-
eration must therefore be given :
1st. To all the factors affecting net earnings as here-
tofore discussed in these articles with a view to
determining the aggregate amount of gross earn-
ings.
2nd. To the contribution if any which the community
as a whole'should make to the earnings as a return
of part of the unearned increment in which all
property owners participate.
3rd. To the cost of operation (including interest on
investment) in so far as the same inures to the
benefit of all consumers.
4th. To that part of the cost of operation which is
incurred for the particular advantage of an indi-
vidual consumer or a limited group of consumers.
These propositions do not need special discussion.
They must be considered somewhat flexible because
no hard and fast rule can be laid down where it is
necessary, as in rate fixing, to adopt a program which
is based on meeting the average requirements and
being fair to large numbers of consumers.
The Remission of Taxes
In the case of express companies, telegraph and
telephone companies, the amount of benefit which
they confer on the community at large in the shape of
an increase of property value is obscure. But this
benefit is real and should be recognized and conceded
to be the result, in part at least, of the operation of
these public utilities. When compared with similar
or other public utilities which are municipally owned,
and which pay no taxes, the question may well be
asked Why would it not be proper to waive taxes
140 PUBLIC UTILITY RATE FIXING
on every public utility throughout the district which
gets the benefit of its service? If this is done for one
utility it should be done for all. The taxpayer who
profits by an unearned increment would thus contrib-
ute to the utility's earnings indirectly (by the reduc-
tion of operating expenses) an amount which would
be saved to the rate payers, who are the owners of
only a part of the property which benefits by increased
values.
Ordinarily little or no consideration is given to
the fact as here set forth that every public utility,
theoretically at least, contributes to the unearned in-
crement of every property holder in the community.
The remission of taxes would be a logical procedure
based on economically sound principles. Or, in case
of water works and gas works, it would be legitimate
to pay liberally for water and gas used for public pur-
poses, thereby returning in whole or in part what has
been paid in taxes. It is unfair to the rate payers, on
the other hand, to accept free of charge, telephone or
other service whereby the burden of the individual
rate payer is increased to the advantage of the tax
payer.
But it will be said, in reply to any contention for
a modification of the common practice in this partic-
ular, that, if carried to its logical conclusion, the public
should not accept a share of the earnings of a privately
owned public utility, as is sometimes done, because
the larger earnings thereby rendered necessary would
be unfair to the rate payer, and on the same theory the
public utility publicly owned should be operated at
a loss in order that by making up the loss the general
public will make an adequate contribution to operating
cost. Such a condition would not ordinarily be ac-
cepted as desirable because of the ease with which the
indirect tax in the gas and water rates, and in the
street car fare can be collected, however unfair and
inequitable such a tax may be.
While some stress has been laid in the above to
the increment which the whole community should
contribute to the earnings of the public utility it must
THE RATE SCHEDULE 141
be admitted that the alternative of putting the load on
the rate payer to lessen general taxation is tempting
and will be difficult to resist, particularly in these days
of stress in which taxation in all possible directions is
being increased by leaps and bounds. When thus
done, as when California transferred the general taxes
for maintenance of the state government to the public
utility rate payers, the collection is so distributed
throughout the year and is so small in the rate payers'
frequent individual contribution that it escapes notice
and comment. None the less it is not equitable and
may in time come to be recognized as unwise. It is
akin to the practice, so often resorted to by the busi-
ness man and manufacturer, of distributing overhead
expenses unequally to their output, so as to make or
hold a market for products that would not sell if
charged with overhead at the full quota determined
by a consideration of net cost only.
Rates for Electric Energy
More attention has probably been given to an
adjustment of the rate schedule to the cost of the
service in the case of supplying electric energy than
in the case of rendering any other public service. There
is good reason for this, because the demand of individ-
ual consumers has an exceptionally wide range and the
consumers are often isolated and scattered throughout
a large territory. The preparation to serve must
be adjusted to the demand of each large consumer
and to the group and frequently individual demands of
the smaller consumers. In the transmission of energy
by electricity perhaps more than in rendering any
other public service the broad principle can be applied
as indicated by the Wisconsin Railroad ommission
that the 1 rates for electric current should be based on
the cost of the service. The electric power concern
adjust-; its installation as stated to a close conformity
with the requirements of individual consumers. This
is not nearly so essential in the case of a water works
which makes its installation to meet the possible
future demand throughout the length of a street or
142 PUBLIC UTILITY RATE FIXING
throughout an urban section generally at a capacity
far in excess of the immediate demand, and which com-
mands with each size of service connection a wide
range of demand. In the one case ready-to-serve
means more to the individual consumer than in the
other.
The electric power concern must make its plant
and transmission lines and the installation to serve
the individual consumer, adequate to meet the collec-
tive and individual requirements. Where the max-
imum demand may at some time reach 500 horsepower
the preparation to serve must be for the amount of
energy. It makes no difference that the average de-
mand may be for only one-fourth of this amount. The
line and transformer installation must be adequate to
supply the maximum amount of energy that may be
called for and the main line must be such that the
service can be rendered at the same time that other
consumers are calling for their allowed limit. The
charge must be adjusted to this condition and the unit
charge if applied only to the delivered energy would
appear higher under such a condition than for another
consumer whose average demand closely approaches
the capacity of his motor installation. There is, there-
fore, when rates are to be fixed a determination to be
made of the cost of being prepared to serve and of the
cost of supplying the energy. The costs thus deter-
mined will then be the guide to the charges which
should be made to make the business profitable. In
line with this reasoning the operating expenses, with
inclusion of interest on the investment, naturally fall
into two classes of which the one class will include
only such expenses as are independent of the energy
output and the other will include those which vary
with the output of energy. The basis of the charge to
the consumer will then be the sum of these distributed
costs with profit added. Consideration of the stable
or demand cost items, in distinction from the variable
or energy cost items, naturally teads to the fixing of
a minimum charge which ordinarily will also cover the
cost of meter reading, billing and collecting.
THE RATE SCHEDULE 143
Gas and Water Rates
The consumer is generally required to pay for
the service connection with gas and water mains. Gas
and water meters are furnished to him without charge.
So long as gas and water are not turned off from any
premises the meters are read, bills are made out and
charges are collected. There is here, therefore, a serv-
ice rendered independent of the amount of gas and
water consumed for which some charge is legitimate.
When, however, premises are vacated and the gas and
water are turned off the premises are restored almost
to the condition of the unimproved lot. The only dif-
ference is the presence of a service connection and a
gas and possibly a water meter which are subject to
a charge for future replacement (depreciation) and to
an interest charge on the capital invested by the util-
ity, if there be any, in the connection and the meter.
These elements of cost are often too small to deserve
serious consideration as the sole basis for a rate, par-
ticularly when such a rate is to be assessed against
vacant premises and would therefore fall into a time
when the owner's income is less than ordinary and he
is least able to pay. Ordinarily there will be so
little difference between the lot with a vacant house
and an unimproved lot that if there is to be a ready-
to-serve charge in the one case the question may well
be asked why not in the other:' If anything apart
from raising rates is necessary to swell earnings
should it not, as alreadv suggested, take the form of
a waiver of taxes or an increased payment for water
used for public purposes?
In the distribution of the aggregate amount to be
earned there will always be some comprehensive or
class treatment necessary which can not be made
absolutely fair to each individual rate payer and prop-
erty owner, lie who lives on the hill top may not at
all times get his water under as great a pressure as
his neighbor at the foot of the hill. Or, again, no
di (Terence will be found in the rates applied to prop-
erty owners in some district which is at so high an
elevation that water must be pumped, and the rates
144 PUBLIC UTILITY RATE FIXING
applied to those whose needs can be met by gravity
flow. In such circumstances the ordinary practice is
to treat the entire municipality as a unit and to regard
the service rendered as no more valuable to the hill top
resident than to the one who lives at a lower elevation.
This is a wise rule ; though there are cases in which it
has not been followed, in which there is an additional
local charge based on pumpage or other similar ex-
penses.
That the unit cost of any commodity or of service
obtained from a public utility should be greater to the
small consumer than to the large consumer will ordi-
narily be accepted as reasonable. But an accentuation
of this disparity by easing up on the large consumer
as his consumption increases, is often unwarranted.
By reference to almost any schedule of water rates
it will be found that the charge for furnishing the
water decreases as the amount increases. This ar-
rangement of the schedule except as necessary to
cover the expenses of meter reading, billing and col-
lecting and the like is not always as unfair to the small
consumer as a mere comparison of the unit rates may
indicate. If the large consumer is conducting an
enterprise which is worthy and needs help from the
community, it may well be claimed that aid should be
extended in some way that will insure a contribution
from all property owners and not under cover of an
inequitable water or gas rate. After provision is made
to obtain from each consumer the special charge
against his individual service, why should not, in other
words, the unit rate for gas and water be uniform to
large and small consumers alike? The answer is that
it should be, whenever the demand for the service or
output of the utility is at the limit of or exceeds the
plant capacity; but that when this is not the case it
may be to the advantage of the small as well as the
large consumer to encourage large scale consumption
even though at less than average rates because revenue
is thereby increased without materially affecting the
aggregate cost of operation. It will not do, therefore,
to condemn offhand a rate schedule because it seems
; 1 1 1 ' losses in relation to going
Boom Co. vs. Patterson, cited value .. 54
on value of land for special Earnings, the adequate include
purposes . 82 a l' ront -
- the excessive 8
Calaveras reservoir lands, val- tlle P*st. how to be consid-
ue of 79 ere * -
California Railroad Commission, --and the rate of return
on the necessity for deter- Electric energy rates
mining a proper rate base.... 162 Eminent domain proceedings 81
California State Supreme Court, Expectation of the term useful-
in San Diego Land & Town ness ils affecting rates 30
Co vs. Geo. Neale et al on Farrington. Judge E. S., cited
land^ value .. in reference to the va]ue of
in Sacramento Southern Rail- reservoir land near San
road Co. vs. Heilbron on ad- Francisco 76-80
missability of evidence inland . citd ' on water'"rig'ht" values
condemnation proceedings... near g an F ranc i sco m
Capital, when to be considered Fortuitous events, amortization
retired out of earnings 9 ,,f ] osse ^ from 39
Chandler-Dunbar Water Power effect 'thereof" upon" rates"" 40
Co. the case of U. S. vs. _ who shou!(i bo;lr tne Iosses
cited on value in condemna- resulting therefrom ... . 41
proceedings 83
Condemnation of land for pub- Gas and waler rates 143
lie use 81 General prosperity is increased
Consolidated Gas Co. case (Win. by the establishment of the
R. Willcox vs. Consolidated public utility 42
Gas Co. of N. Y.) cited on Georgia Railway Co. vs. Ala-
appreciation 07 bama Railroad Commission,
- cited on the rate of return 132 cited in reference to right-of-
Cost. the original and the legit- way value 87
imate investment 6 Going value 5, 8,
of reproduction and the nat- 27. -19, 50. 51, o'_'. 53, 54, 55. 56
ural rate base fi Brewer. Justice I'. S. Su-
of developing business 7 preme Court quoted 50
165
166 PUBLIC UTILITY RATE FIXING
Page Page
cost of developing business should be adequately pro-
as a measure thereof 51, 54 tected 121
cost of developing business Knoxville waterworks case,
is not the going value 53 cited on past history 6, 7
determination of 51
Hazen, Allen, quoted 56 Lake Merced, San Francisco,
in its relation to the vol- California 154
ume of business 55 Land, value of 59, 60
in the San Francisco rate earning capacity as a basis
case 49 of its value 60
how affected by early losses 54 See: real estate,
hypothetical reproduction as Lewis, A. A., of the Public
an aid in determining the Service Commission of Wash-
sarre 52 ington, contends for a rate
MorrowV'judge'w.'w! '"quoted 50 base which is not value 162
not dependent on the in- Lux vs. Haggin, referred to in
vested capital 55 relation to riparian rights 110
the basis thereof is found in
the earnings 55, 60
Van Fleet Judge W. C. Management, compensation for,
' . . 50 may appear as interest on the
Wright,'"H.'~"M.7' Master "in ^oing value 42
Chancerv, San Francisco compensation for can be
water rate case quoted 49 brought into relation to the
-U. S. Supreme Court quoted 50 volume of business 43, 45
Goose Lake. California, cited as -compensation therefor
an undesirable storage site.... 65 should not be based on -
Grunsky, Capt. C. E.. Jr., on
"Fair Value and the Rate hazard and the unearned
Base," Chap. X 156-164 increment
Government ownership of rail- Market value (see Value)
roads 150 Mathematical demonstration of
error in the ordinary formu-
las for depreciation and pres-
ent value 92
Hazard, compensation therefor Merced Lake, in San Francisco,
may appear in the rate of value of site 75
return applied to going value 42 cited as having value due
compensation therefor to storage capacity rather
not be brought into rela- than to water production.... 154
tion to value 41, 43 Metcalf. Leonard, quoted on de-
in the Consolidated Gas Co. velopment expense 56
case 41 Methods of procedure in rate
management, and the un- fixing illustrated 20
earned increment 41 Minnesota rate cases, cited on
the volume of business as the right of way and land
a basis for an allowance value 86
therefor 43, 45 Morrow, Judge W. W., quoted
Har.en, Allen, quoted on going on going value 50
value 56
quoted on appreciating land
values in the San Fran- Natural rate base 3, 6, 29, 151
Cisco water rate case Obligation of the publin when
Hjpothetica! reproduction as an it reffu i atea pu bn c utilities 127
aid in estimating going value 52 obsolescence, defined 34
ran not be forecast 34
past experience is not a de-
Idaho Supreme Court,_ aban- pondahle guide for its deter-
dons "present value as a mination ... . 35
rate base in the Pocatello _ and replacement reau ire-
water rate case menif compared 35
Intangible elements of value.... should affect rates subse-
Intangible elements have value quent to and not before the
as the result of earnings.. ..52, 5 event 36
Interest and rate of return illustration
Interstate Commerce Commis- Owners' of public" "util'i ties'." "the
sion, cited in the \Vestern ri hts of 2g
Advanced rate case 99
Inventions, their introdu'-tion
should be rewarded 11 Pacific Telephone & Telegraph
Investment, and the natural rate Co., contend:-! for a proper
base 3. 6, 151 rate base 162
INDEX 167
Page Page
Peninsula reservoirs of the value as a rate base, not
Spring Valley Water Co. sys- satisfactory 2, 161
teni supplying water to San Rate Fixing, elements requiring
Francisco, value of 77 consideration 34
Pilarcitos reservoir lands, value fundamental principles, il-
of 77 lustrated 20
I'ocatello water rate case, cited railroads 20
on the abandonment by the steamboat 22
Idaho Supreme Court of pres- waterworks 23
ent value as a rate base 160 general comments on 1
cited on accrued deprecia- unlimited life method 33
tion 14 Rate of return 121, 125
Population growth, California illustrations 128
and the San Francisco Bay in the San Francisco water
region 71 rate case 132-134
Population growth and appreci- Rate payers, the rights of 27
ation of real estate 67-75 Rate Schedule 135
Alameda County, Cal 74 problems relating to 136
Contra Costa County, Cal. 72 and the unearned incre-
San Francisco City and ment 138
County, Cal 68 determining factors 139
San Mateo County, Cal 69 electric energy rates 141
Santa Clara County, Cal 70 gas and water rales 143
Present value as a rate base..-. remission of taxes as affect-
2, 27, 91, 151, 152, 158, 160 ing 139
Probable life of articles does railroad rates 147
not agree with their actual Street car fare 145
terms of usefulness 30 Rates are not uniform to all
- -mathematical demonstration rate payers 135
of error in the calculation Rates, should not be affected by
of present value and of de- accrued depreciation 2
preciation due to this non- -how affected by fortuitous
agreement 31, 92 events 39
Profit, in its relation to value.... 10 how affected by obsoles-
in its relation to volume of cence 36
business 10, 47, 48 Real Estate appraisal for spe-
as a reward for skill and cial use 59
good management 11 -court decisions on market
Public, the rights of the 28 value of 82
its obligations when it reg- in condemnation proceed-
ulates public utility rates.... 127 ings, admissibility of evi-
Public Service Commission of dence 84, 85
Washington on the rate base value of for ordinary uses 88
in the telephone case 162 value in eminent domain
Public Utilities and general proceedings 81-89
prosperity 97 Real estate in the San Fran-
Public utility, the, and the un- cisco Bay region, increasing
earned increment 15, 97 value of 67
- the, may be regarded as Alameda County, Cal 74
having unlimited life 33, 90 Contra Costa County, Cal. 72
S>an Francisco City and
County, California 68
Railroad Commission of Cali- San Mateo County, Cal 69
fornia on necessity of estab- Santa Clara County, Cal 70
lishing a proper rate base.... 162 Replacement requirement (cur-
Railroad rate schedule 147 rent depreciation) 12
the long and short haul determination of current
question 147 replacement requirement is
Railroad rates, require adjust- essential 95
trent to a number of factors 150 Replacement (depreciation) fund 13
Railroads in competition with Reservoir lands not yet in use.
water transportation 149 value of 80
Rate Base 2, 3, Reservoir lands, factors to be
1-2. 14, 15. 16. 19. 151, 152. 160 considered in making the ap-
and appreciation 19, 152 praisal 61
and the bonus 14 - market value is difficult to
and donated property 15 determine 66
- and value of water rights 16 sale* of similar properties
- court decisions imixjse re- considered 62
strictions upon 152 value of 59
--the natural 3, 6. 20, 151 -value of, near San Fran-
the satisfactory 159, 160 cisco ... fifi
168
PUBLIC UTILITY RATE FIXING
Page
Reservoir for storage reduces
waste 63
Reservoirs of the San Fran-
cisco Bay region 64
Reservoir site, determination of
availability 62
Reservoirs of large extent may
have small storage value 64
Rights of way, the value mul-
tiple 85
Riparian rights, doctrine estab-
lished in California 110
Rudkin, Judge F. H., on the
rate of return in the San
Francisco water rate case 134
San Andreas reservoir lands,
value of 77
San Antonio reservoir site,
value of 78
San Francisco Bay region, in-
creasing value of real estate 67
San Francisco City and County,
growth of population and in-
creasing value of real estate 68
San Francisco water rate case,
see Spring Valley Water Co.
vs. San Francisco.
San Joaquin and Kings River
Canal and Irrigation Co. vs.
the County of Stanislaus, de-
cision of the U. S. Supreme
Court on water right value.... 102
San Mateo County, Cal., growth
of population and increasing
value of real estate 69
Santa Clara County, Cal.,
growth of population and in-
creasing value of real estate 70
Service, quality of by public
utility unaffected by depreci-
ation 2
Shaw, Jas. T., quoted in favor
of a rate base which differs
from value 161
Smyth vs. Ames, U. S. Supreme
Court cited on reasonableness
of rates 156
Spring Valley Wa'.er Co. vs.
San Francisco (San Francisco
water rate case), 49, 50, 50. 75, 79,
109, 111, 116, 132, 133, 152, 154
Steamboat, as an illustration of
methods of procedure 3
Strategic value of water rights 105
Street car fare 145
--the zone system 146
Street car operation, essentials 147
Supreme Court of California,
see California Supreme Court.
Supreme Court of Idaho, aban-
dons present value as a rate
base 160
Supreme Court of the United
States, see U. S. Supreme
Court..
Taxes, assessed to public util-
ities 139
Thorintrton, Special Master,
cited on right of way value
in Georgia Railway Co. vs.
Alabama Railroad Commission 87
Page
Tulare Lake, Cal., cited as of
small value for storage 65
Unearned increment
15, 19, 41, 42, 43, 45, 138
Unearned increment, allowance
for participation in general
prosperity brought into rela-
tion to the volume of busi-
ness 43, 45
allowance therefor should
not be based on value 41
allowance therefor may ap-
pear in the rate of return
applied to going value 42
of property owners, gen-
erally, is affected by the es-
tablishment of a public
utility 15
and the public utility 42
and the rate schedule 138
Unlimited life method of pro-
cedure in fixing rates 33, 95
Unlimited life of public utilities 90
United States Supreme Court,
in Doom Co. vs. Patterson on
the value of land for special
purposes 82
in Consolidated Gas. Co.
rate case, on appreciation 97
in KnoxviMe water rate
i-afe on depreciation :.. 6, 7
in Minnesota rate cases, on
the value multiple 86
in San Joaquin and Kings
River Canal and Irrigation
Co. vs. the Ccunty of Stan-
islaus, on the value of
water rights 102
in Smyth vs. Ames, on the
reasonableness of rates 157
in United States vs. C'nand-
ler-Dunbar W a t e r Power
Co. on the value of land.... 83
'Valuation, Depreciation and the
Rate Base.' by C. E. Grun-
sky, quoted on past history of
the public utility 7
-quoted on the replacement
requirement 95
- quoted on water right value 16
VaU'.r.tion for rate fixing pur-
poses, in a formative stage.... 163
- -of reservoir lands, factors
to be considered 61
---'"or taxation purposes, San
Francisco Bay region 73
Valle reservoir site, Cal., \alue
of 78
Value
as a rate base illogical and
impractical 2, 151, 158
as a rate base and invest-
ment contrasted 27
of irrigation water 101
of Innd, circumstances af-
fer;in.sr 59
- -of reservoir lands 59
of reservoir lands not yet
in use .. . 80
INDEX 169
Page Page
of reservoir land in the San Volume of business, as the
Francisco Bay region 75 basis for a profit allowance 10, 20
of reservoir land in the San and public utility rates
Francisco Bay region is in- 43, 45, 46, 48
creasing 67 Washington, State Public Serv-
of a water right ice Commission, on the rate
16, 18, 25, 85, 101-103, 105, base in the telephone case.... 162
108, 108, 112-114, 116, 117, 119 Water power, compared with
Anderson, Geo. G. in ref- steam power 18
erence to 116 - development of should be
Hermann, F. C., in ref- encouraged 107
erence to 116 Water rates 143
Lee, C. H., in reference Water right value, see "Value
to 116 of a water right."
affected by its life 108 "Water transportation, in its
created by earnings 1( efTeet u railroad rates 149
by comparison with val-
ues elsewhere 112 Water-works, valuation as a
is affected by additional basis for rates> illustration.... 25
development of water.... 113 Wright, H. M., Master in
indicated by sales of the Chancery, San Francisco
stock of mutual irriga- water rate case
tion water companies.... 114 quoted on going value 49
determined from the en- - quoted on rate of return
hanced value of irrl- for a going concern 57
gated land 117 quoted on the rate base in
is affected by an obliga- the San Francisco water
tion to supply water at rate case 152
less than cost 119 quoted on the rate of re-
and the rate base 16 turn in the San Francisco
may be strategic value 105 water rate case 132
in the San Francisco quoted on reservoir land
water rate case 109 value in the San Fram-isro
Value multiple, as applied to water rate case 75-80, 154
rights of way 85 quoted on water right val-
Van Fleet, Judge W. C., quoted uea in the San Francisco
on going value 50 water rate case 109-112
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