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 UC SOUTHERN REGIONAL LIBRARY FACILITY A A 000030256 2