Regulatory and financial aspects of the utility industry rate treatment of construction work in progress

Growth in utility construction programs has focused attention on the methods used by utilities to obtain the earnings needed to pay investors for the use of funds for construction expenditures. One method is to add an amount to net income, called Allowance for Funds Used During Construction. (AFUDC). The contra account is capitalized interest which is added to the cost of plant and depreciated over the useful life of the asset. A return is allowed on the unamortized portion of such capitalized interest. Such AFUDC earnings are derived from accounting entries, and are therefore considered to be in the nature of construction earnings. The alternative is to include construction work in the rate base and permit the utility to earn a financial return on such amounts. That financial return is in the nature of operating earnings. Regulatory objection to this alternative is that existing rate payers are asked to pay rates based upon plant intended to serve the requirements of future customers. The literature generally suggests that the market treats AFUDC earnings as less valuable than operating earnings. Four hypotheses were tested dealing with the impact of AFUDC upon the market value of common stock, the extent to which any adverse valuation is influenced by the size of the construction program, and by the level of the AFUDC rate. Empirical testing was performed using both the Modigliani & Miller, and the Litzenberger and Rao stock valuation models. Collateral testing was also performed using Second Degree Stochastic Dominance. Results confirmed that AFUDC adversely affects the value of common stock. Tests of the influence of the level of the AFUDC rate upon stock valuation were inconclusive. Other testing shows a partial inclusion of construction work in the rate base will greatly limit any adverse market treatment of construction earnings.