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Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

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What Warren Buffett Can Teach Us About Utility Depreciation

The so-called “Woodstock for Capitalists”, the Berkshire Hathaway annual meeting in Omaha, has just concluded. One shareholder resolution, which was voted down, would have reviewed the impact of climate change on their reinsurance business. As a large commercial reinsurer, the prospect of hurricanes, tsunamis, storms surges and coastal flooding are no idle threat. Mr. Buffett’s commented that since policies are reviewed annually, changing perceptions of risk and appropriate compensatory rates are addressed at that time.

From a business perspective this is an attractive and seemingly flexible position to be in: raise prices or even deny insurance coverage if the risks become too great or too costly. Electric utilities with their geographically fixed, monopoly service areas in the U.S. have no such flexibility. For them, especially companies in low lying coastal areas, geography may prove to be destiny. Related: Oil Prices Fall Back as Rally Hits a Ceiling

From an accounting perspective part of the role of insurance is to protect assets of the business against loss. But what happens if the entire service area is at risk in the longer term? We’ve all seen dramatic projections of the U.S. coastline in the year 2100 under various rising seas scenarios. Florida beachfront property could mean the outskirts of Jacksonville and the New Orleans Jazz Festival will be held in Baton Rouge or, worst case, Shreveport. Unlike Mr. Buffett’s reinsurer with their annual policy reviews, utilities are tethered to specific service areas.

Even before considering climate impacts, utilities today face challenges on numerous fronts: transition from coal to gas, emergence of competition and the search for appropriate business/regulatory models. Adding the adverse financial impact of climate change to these existing concerns seems like piling on. Related: A 4.5-Million-Barrel Per Day Oil Shortage Looms: Wood Mackenzie

For financial analysts climate change raises questions about appropriate rates of depreciation. If long lived distribution assets for example need more frequent replacement due to increasing frequency and severity of storms, perhaps industry depreciation schedules should be revised to reflect this. However doing so would raise this non-cash charge to earnings with a corresponding decline in earnings. For an industry that prides itself on paying out a hefty percentage of earnings in dividends, this could prove a bitter pill to swallow and raise uncomfortable questions about appropriate payout ratios. There are alternative solutions — raise electric rates to cover the increased depreciation or raise the allowed return to reflect added risk — but they both require regulatory approval. Imagine the difficulty of convincing the commissioners to raise electric rates to cover possible future costs.

We don’t know how the utilities and regulators will handle this matter. But the immediate question is whether coastal utilities in particular should consider accelerating depreciation to account for the corrosive impact of climate change on their assets or whether someone else will force the decision on them? The mortgage industry may suggest an answer in terms of one of their less savory historical practices, “redlining.” Neighborhoods, typically with a high percentage of minority residents, were “redlined”, typically in red pencil, to indicate to mortgage officers the areas where the bank had little interest in doing business. Related: Why Iran’s Shale Oil Discovery Won’t Add To The Glut

In the near future, it is the bond rating agencies that may do the “redlining” with respect to utilities. As distribution assets face ever more frequent replacement and low-lying portions of a service area may even face ultimate abandonment, perceptions of financial risk are likely to rise and bond ratings likely to fall with an attendant adverse impact on cost of capital.

Thinking about the impact of rising sea levels is a lot like depreciation. Knowing the “correct” rate is impossible barring clairvoyance. The only comfort investors can take is in knowing that managements are conservative in their assumptions. It may not be much. But right now it’s the best they can offer.

By William Tilles and Leonard Hyman for Oilprice.com

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Leave a comment
  • Mark Harkness on May 06 2016 said:
    I usually read your analysis with interest, but this one is a real clunker. I'm not a climate change skeptic, but worrying about something that might or might not happen 100 years in the future is just plain stupid. A lot will change between now and then. We have much more pressing concerns.
  • B Tilles on May 09 2016 said:
    Dear Mark,

    Thank you for comment and sorry for the late response.
    In your comment you basically said three things: 1) it's stupid of me to worry about climate stuff a long way off; 2) lots will happen betw now and then; and 3) we have better things to worry about.
    I agree with everything you wrote.

    Our point was about depreciation. Using incorrect depreciation rates has adverse financial consequences. Earnings and assets are both overstated. To us that's a big deal. Unrealistically optimistic depreciation serves the purposes of management (earnings look better) as well as regulators (lower expense growth lessens rate increase requests). And if the rating agencies begin to express concern, funding costs could rise. For an industry with no growth that's trying to reign in price increases, this makes life tougher. That's why we thought it mattered.

    Bill T./Len H.

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