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Transactions of the American Society of Civil Engineers (Volume 81) online

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tion that costs are values.

In competitive industry it is held to be fair that the investor
obtains a greatly vai-ying rate of return on his investment, the amount
of which depends mainly on the industrial capacity of the promoters
and managers of the enterprise, but partly on changes in the indus-
trial world occurring independently of the management. Competition



DISCUSSIOX ON VALUATION OF PUBLIC UTILITIES 1599

is relied on to assure the fairness of prices. The independence of pri- Mr.
vate ownership is only practicable when the owner secures the profit ^^^^'
and loss resulting from judicious or injudicious choice of enterprise,
from good or bad design, or from other differences in efficiency of
management. The Committee proposes in its main argument that the
fairness of regulation be judged by the return secured by individual
investors. The writer maintains that, with private property, this is
not practicable. The return of the individual enterprise miust vary
greatly with efficiency, and the efficiency can only be practically
judged from the rate of return secured under conditions prescribed in
some other way than by trying to secure a uniform rate of return in
individual enterprises.

The Committee not only advocates such a regulation, for natural
practically complete monopolies, as will give a uniform rate of return
in individual enterprises, but assumes in much of its reasoning that
such, if any, regulation has actually existed in the past and ought to
have existed where all regulation was absent. As a matter of fact, no
such regulation ever did exist, and never ought to exist. Many of
the Committee's inferences in regard to values, depreciation, and the
proper future rates based on such assumptions, therefore, are in error.
The activity of regulating commissions is generally limited to reduc-
ing grossly excessive prices where consumers complain. They then
endeavor to fix such prices as will, in their opinion, with average effi-
ciency of management, produce about the same rate of profit as in
local competitive industries at the same time. The price adopted is
mostly and necessarily, since the required facts are missing, an ap-
proximate guess, unsupported by adequate evidence. Actual values of
enterprises thus regulated, therefore, are widely different from those
which would have resulted from the imaginary regulation advocated
by the Committee, and which it endeavors to determine.

Where competition remains an important element, no attempt is
ever made to secure a uniform return on the investment in individual
enterprises, for the very good reason that it would not be practicable.
The fundamental principle which governs commerce and should
govern regulation and valuation is : "Be careful what you promise
and keep your i)romises."

In granting franchises, in the past, the public, generally, has not
been careful in its promises, and has often made it very difficult or
impossible, without gross injustice, to keep the promises it made.
The economic developments of the present were not foreseen in the
past, and the promises made were so extremely indefinite that it is
generally impossible to determine accurately what was promised and
to keep accurately the promises. In commerce, it is sometimes found



1600 DISCUSSIOX ox VALUATION OF PUBLIC UTILITIES

Mr. just, under exceptional unforeseen circumstances, by a moratorium to
^^^^' relieve merchants of given promises to pay their debts when due.

The case of unreasonable public franchises is in some respects
similar, and there are cases when justice requires expropriation on
fair terms. Regulation was introduced that was not provided for in
many of the franchises, and was frequently modified in such an un-
expected manner as to affect seriously the net earnings and thereby
the values of enterprises. Though the principle of keeping promises
is thus frequently disregarded, it nevertheless remains a valid prin-
ciple whenever it is possible to follow it without serious injustice.
Another necessary principle governing valuations follows from the
nature of value.

From the definition of value, cited by the Committee in the Glos-
sary, it follows that the value of a public utility, the securities of which
are largely dealt in on the exchanges, can be most closely obtained from
a study of the quotations in the stock exchanges, and the amount of
securities outstanding. The security quotations represent an estimate
by the market of the present value of the future income expected to
be paid to the owner of the securities.

This future income and the current quotations measure the value
of securities, and they are what the owner values and what the Courts
endeavor to protect. The future income depends largely on the future
regulation. This latter is not exactly known, but its nature is inferred
from the present legally established regulation and the knowledge that
the Courts, generally, will not sustain svich changes of the existing
regulation as will destroy present values, as well as from the necessity
of regulating prices so that it will be possible to secure the needed
capital for building new properties, for extending old ones, and for
rendering satisfactory service.

To ascertain the present values of future revenue, the rates of
interest to be adopted must be known. Such rates must be chosen as
will make, for enterprises the securities of which are largely dealt in
on the exchanges, the value inferred from future net revenue the same
as that inferred from the security quotations. The Committee pro-
poses to find the values of public utilities by determining first the
tangible and then also the intangible value, giving the latter due
weight.

By strict logic, the total value is equal to the tangible plus the
intangible value, and as the intangible value is equal to the exchange
or market value, derived from estimated future net revenue and quo-
tations, less the tangible value, their sum, or the total value, is equal
to the exchange value.

The determination of the tangible value, therefore, is at best only
indirectly useful for the purpose of valuations. The Committee pre-



DISCUSSIOX OX VALUATION OF PUBLIC UTILITIES 1601

fers, however, not to be logical. It infers, from the fact that the Courts Mr.
give round sums for the intangible value, that the entirely indefinite ^^^^'
phrase giving due weight to the intangible value must be substituted
for the exact request to add the intangible to the tangible value. There
is abundant reason for using round figures for the result of any valua-
tion, however determined. It is improper to use exact figures when
the degree of accuracy obtainable by any kind of valuation does not
justify anything else but round ones. Another reason given is that
the Courts do not assert that the value must be found by considering
income and quotations alone. It might also be stated that the Courts
expressly assert that costs are one element to be considered. The
Courts, however, do not state how the value is to be determined from
the various elements which must be considered. The cost and the
average life of every perishable part of an industrial enterprise must
be known in order to determine its annual decretion which is a part
of the operating expense. The net earnings, therefore, cannot be
determined without knowing the costs of the perishable parts of the
plant. For determining what prices must be allowed to secure capital
for enterprises capable of rendering the same service, and thereby to
choose a fair regulation, the costs of a substitute enterprise are of
importance. In a valuation based on net revenue, costs, therefore, are
considered in two ways : First, in choosing the regulation to be
assumed; and second, in determining the net earnings resulting
therefrom.

The Committee endeavors to show that the kind of regulation it
advocates does not necessarily destroy efficiency. For this purpose it
again departs from logic. It desires a regulation which makes tan-
gible value equal to exchange value. This can only be attained by
making the return on the investment proportional to its amount. It
then recommends a departure from this uniformity by advocating the
London and Massachusetts sliding scale of dividends.

The instance cited is the allowed 7% dividend for 90-cent gas with
i% increase of dividend for every cent of reduction in the price of
gas. The gas company, under this rule, now obtains 9% dividends
with 80-cent gas. In competitive industry, when a producer reduces
costs of production he obtains himself the profit from the reduction
of cost until the improvement is adopted by enough of the competitors
to increase the supply materially; then prices and the profits of all
producers are reduced, and the backward ones are compelled to im-
prove, or receive abnormally low profits. After a short time, average
profits are the same as before, and the public gets the benefit of the
improvement. During the transition period, those in advance gained,
those in the rear lost.



1602 DISCUSSIOX ON VALUATION OF PUBLIC UTILITIIiS

Mr. With the sliding scale, when an improvement reducing costs is

. ajer. ^^^^^ {^y ^^^ q^q ^j^^ widely adopted, all, whether fast or slow, obtain
a permanent increase of dividends.

The inducement to make the first trial of improvements is greatly
reduced; that to wait until they are well tried out is increased.

Improvements are discouraged, and permanent excessive dividends
result from those adopted. The sliding scale is unfair to the public;
therefore, it does not spread. The two requirements, fair prices and
high efficiency, are not, and cannot be, secured by the methods of reg-
ulation advocated by the Committee. They can be secured by improved
franchises for all natural monopolies.

The franchises should all be definite competitive operating con-
tracts for limited periods of time.

Such a contract should be based on unit prices for the work per-
formed, which work should be as accurately described and enforced
as that described in a contract for building a large engineering struc-
ture. The contract must contain such clauses, referring to deeretion
and the compensation for the plant of the contractor, if any, at the
end of the operating period, as 'vill assure adequate maintenance and
exact determination of the payments for such plant. If old, the prop-
erty forming the subject of the operating contract must first be
obtained by the public by a valuation based on the present value of
the future net revenue with the present regulation, unless good reasons
exist for believing that the present regulation is unfair. In this latter
case, such a regulation, in harmony with promises made, should be
assumed as will make it possible to secure capital for new properties
capable of rendering equal service and for extending and satisfactorily
operating old ones. If there is a good market for the securities, the
value should also be determined from a study of the quotations.

For valuing the property and, later, for determining the annual
deeretion, an inventory must be made giving an estimate of the
original cost, age, and average life and scrap value of every perishable
part of the plant; oi*, where these are unobtainable, an estimate of
the present value, the remaining life, and the scrap vahae.

For determining every year the deeretion of the plant, which is a
part of the operating expenses, the deeretion must be defined so that
it can be accurately determined and so that it agrees as closely as
possible with the facts.

The following rules will serve for this purpose:

The nominal annvial deeretion of any part is the difference between
its cost and its estimated scrap value divided by its estimated average
life. The actual life and scrap value are different from the estimated
average life and the estimated scrap value. To correct the errors



discussio:n^ on valuation of public utilities 1603

resulting therefrom, the following rules become necessary for calcu- Mr.
lating the actual decretion every year. ' ^^^^'

For parts in use and younger than their estimated average life,
take the nominal annual decretion; for parts in use and older than
their estimated average life, take no decretion; for parts discarded
during the year, take the cost less the decretion previously allowed
for, and consider the actual scrap value as part of the earnings.

These rules take an estimated decretion for parts in use for which
the actual one is unlaiown, and correct the therefrom resulting error
as soon as the actual decretion becomes known by the discard and sale
of parts. They, therefore, give as close an approximation as prac-
ticable of the actual decretion.

By means of the inventory and the rules for decretion received by
the bidders, the decreted cost of the plant can be ascertained at the
end of every year. If the decretion thus determined is considered a
part of the operating expense and placed in a decretion fund to be
used for replacements, improvements, and extensions, without thereby
increasing the cost accoimts, the plant will be efficiently maintained.

New capital is required for most plants, and any operating con-
tract must contain clauses prescribing who is to furnish such capital
for extensions and increase of capacity, and the compensation it is to
receive. The public is interested in all parts of the plant which may
survive the contract, and a board of engineers representing the public
must have a controlling voice in selecting and supervising the acquisi-
tion of new plant. An operating contract must describe the kind of
service v-anted as well as the maximum prices to be charged, based,
in an old plant, on the previous ones, with such changes as appear
advisable at the time of framing the contract. The operating com-
pany should be permitted to reduce, but not to increase, the prices.
The contract should be framed by representatives of the public. Invi-
tations to bid should be sent out giving all the available information
required by bidders to assist them in calculating the net earnings
during the period of operation, which might be about 20 to 30 years.
The company should be required to surrender the plant at the expira-
tion of the contract at cost of the parts, if any, furnished by the con-
tractor, with the approval of the representatives of the public, during
the period of the operating contract, the decretion fund going with
the plant.

The bidders should be asked to give the annual rental which they
are willing to pay. The contractor must furnish a guaranty for at
least one year's rent, which should be payable monthly out of the net
earnings, if possible. If the guaranty fund is encroached on, the con-
tractor should be required to replenish it. A quick foreclosure, in
case of non-fulfillment of conditions, should be part of the contract.



1604: DISCUSSION ON VALUATION OF PUBLIC UTILITIES

Mr. By such provisions, large contracts can be awarded safely to bidders
^^'^'^' backed by a moderate capital. This will make real competition pos-
sible for every large enterprise.

This, though quite incomplete, will give a general idea of the kind
of definite competitive contract that should replace the present indef-
inite franchises, in which protection of the interests of the public is
obtained by commissions having, among many other indefinite powers,
that of prescribing and changing without compensation, after award of
the franchise, the prices of the products and services furnished by the
operating or owning company. Changes are necessary in any long-
term contract. Therefore, there must be provision for making them
without changing the value of the contract.

The two contracting parties should be on an equal footing, and
their respective rights and duties should be defined exactly.

With such a contract, fair prices would be assured by competitive
bids for contracts of such size as will assure active competition.

Efficiency is secured because the profit or loss of the contractor
depends entirely on his efficiency. The drawing up and enforcing of
such a contract does not require the superhuman knowledge and
ability that would be necessary for assuring efficiency and fair prices
by the present methods of regulation. Only one valuation is required
for each old enterprise, that for acquiring ownership of the property.
All succeeding transfers would take place for sums based on costs and
decretions, defined in advance so that they can be determined
accurately.

Reviewing the foregoing discussion: the problem to be solved is to
replace adequately the self-regulating competition which has disap-
peared either partly or altogether in some fields of productive industry.
Where free competition prevails, fair prices and efficiency are secured
automatically by increased supply and falling prices, in industries
where average profits are excessive, and reduced supply and rising
prices where they are abnormally low. The fairness attained is not
equal profits for good and bad management but, in the long run,
approximately uniform average profits for the same degree of indus-
trial capacity in different industries. Efficiency is secured by profits
depending mainly on it. The return on the investment in the indi-
vidual enterprises of every industry varies widely with the economic
skill shown in their promotion and management, and partly with
unforseeable economic changes outside and independent of the manage-
ment. The board of directors, consisting of, or representing, the
largest stockholders, has generally no other common primary aim
than the, in the long run, largest possible return on the investment.
The value of the business may be a small fraction of the investment
or may exceed more than ten times its amount. An industrial enter-



DISCUSSIOX ON VALUATION OF PUBLIC UTILITIES 1605

prise is a tool for the production of a future net revenue; its value is Mr.
the present value of its future net revenue; this, on an average, ^^y^""-
depends mainly on the cost of production of the business, but, in indi-
vidual cases, mainly on the industrial capacity of the management.
This deviation of the value of such an enterprise from its cost of pro-
duction is vphat produces efficiency of promotion and management
without public control, and makes private property of such enterprises
practicable.

The directors will endeavor to secure, and will retain, the most
efficient managers. Were uniform profits guaranteed, as is proposed
for the ideal regulation of the Committee of completely monopolized
industries, a crowd of incompetent promoters would encumber the
field of new enterprises, and the directors would probably choose their
sons, nephews, and friends for the leading positions, and would follow
the same method in selecting the minor officers.

Since, with uniform profits, the public pays for good or bad man-
agement and carries the risks, it will gradually insist on full control
of promotion and management, independent private property will dis-
appear, and public operation and ovsTiership will result almost auto-
matically. Uniform profits for individual enterprises are incompatible
with private operation, because, inevitably, they destroy efficiency of
management. The only possible alternatives, therefore, are public
operation, and private operation with profits in individual enterprises
mainly depending on efficiency and with average profits in every
monopolized industry, the same as the average profits of competitive
industries at the same time and place.

The frequent inefficiency of public operation in democratic com-
munities arises from the method of choosing the public equivalent of
the board of directors, and the general manager and his assistants.
They are either elected directly or are appointed by representatives
elected for other qualities than their knowledge of the industrial enter-
prises under public management. The voters and their representatives
generally know little about these industries.

The management is controlled frequently by the most powerful
politicians of the day, and will remain in power through its control
of votes. It is often dependent on the politicians in its appointments
and discharges of employees and the choice of their salaries and
wages, in the prices charged for services rendered to the public, and
sometimes, also, in its purchases of materials and supplies as well as
in the choice of improvements and extensions.

In attaining and keeping in power, the efficiency of management
is a very small factor, and, therefore, is largely neglected.

A private board of directors in a company with a fixed rate of
dividends would be worse, but a private board with a rate of dividends
depending mostly on efficiency is far superior.



1606 DISCUSSION ON VALUATION OF PUBLIC UTILITIES

Mr. There is, therefore, no reasonable doubt that, as long as the evils

■ described prevail, private operation vs^ill secure a cheaper and better
public service when the net earnings of the private company depend
mainly on efficiency of promotion and management. One way of
securing the fairness defined as equal average profits in each monopo-
lized and in competitive industries, combined with the efficiency of
management resulting from profits in individual enterprises depending
mainly on efficiency, consists in replacing the kind of competition
which has disappeared, because it is impracticable, by another kind
which is practicable. This consists in acquiring public ownership of
all partial and complete monopolies, and selling definite operating con-
tracts for limited periods to the highest bidder. Two necessary fea-
tures of such contracts, which have been given insufficient attention
in past franchises, are an exact definition of the annual decretion and
of the price to be paid to the contractor or owner, either when he fails
to comply with the terms of the contract or at the end of the operating
period.

Another feature of such contracts, not mentioned in the foregoing,
is the possibility of prescribing exactly in the contract, without injus-
tice to the contractor, the minimum wages and other working condi-
tions approved by public opinion, and the manner in which they are
to be changed without changing the value of the contract.

Near-by economic changes, occurring independently of the con-
tractor and influencing the net earnings, can be foreseen largely by the
bidders and allowed for in the bids. Distant changes, which cannot
be foreseen, will influence future bids in the same manner. Approxi-
mate proportion of efficiency and net earnings will be secured thereby.
In such contracts changes in the value of the lands occupied by the
enterprises accrue mostly to the public to whom they belong. They
are caused largely by events beyond the control of the contractor.
Justice requires, therefore, that they should not affect his revenue.
In these respects public ownership with the private operation herein
described is more just than private property in competitive enterprises.
Another advantage is the much greater stability in the value of all
securities representing part of the incorne of either the property
operated or of the operating contract. With publicity of accounts and
exact determination of the annual net earnings,' the value of the con-
tract can be judged much more accurately than that of a partial or
complete monopoly regulated in the present necessarily arbitrary
manner.

Transfer of the property from one operating company to the next,
based on costs, when agreed on by contract, is far superior and is more
just than transfer based on values. Costs can be ascertained accurately
when followed from the start, values never; costs make the contracts



DISCUSSION ON VALUATION OF PUBLIC UTILITIES 1607

definite, values indefinite. This change from the general practice of Mr.
using values instead of exactly defined costs, in defining the terrns of *^^''
transfer, is what makes short-term operating contracts practicable.
The other method of securing fair prices, together with efficiency
(which are both essential), is to fix, by regulating commissions, from
time to time, the kind and quantity of service to be furnished by par-
tial or complete monopolies and the prices which they are permitted
to charge.

The prices are fair when they make the average profits in every
monopolized industry the same as in competitive ones; they secure
efficiency when the profits in every individual enterprise are in pro-
portion to efficiency of management. To fix the prices, it is necessary,
therefore, to ascertain, first, the average profit secured in competitive



Online LibraryAmerican Society of Civil EngineersTransactions of the American Society of Civil Engineers (Volume 81) → online text (page 145 of 167)