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

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industries at different times and places. By profit of an enterprise
is meant the percentage of net earnings on its value. The sum of the
values of a large number of well-selected competitive enterprises and
the sum of their net earnings must be ascertained. The latter mul-
tiplied by 100 and divided by the former giv.es the average competitive
profit.

Though the value of individual competitive enterprises varies
greatly from their cost of production, the sum of the values of a very
large number, representative of all competitive enterprises, is approxi-
mately equal to the sum of their costs of production. This results
from the tendency of capital to flow to the most profitable investments,
which makes the average return of all kinds of otherwise equally
attractive competitive investments the same. The value of the sum,
but not the value of each, can be determined, therefore, from cost of
production. The average profit of competitive enterprises can be
determined, therefore, if the necessary facts are ascertained.

With any given regulation, the average profit in any monopolized
industry can be determined in a similar manner from the sum of the
net earnings and that of the costs of production of the enterprises.
The average profits thus ascertained should be the same in competitive
and in every monopolized industry. This assures fairness of the regu-
lation as a whole. If the profits are found to be different, the regula-
tion should be changed so as to make them alike.

The regulation in detail must prescribe different prices in different
places with different costs of production. The differences in cost of
production in different places with ordinary methods of production,
therefore, must be ascertained.

Although it is theoretically possible to regulate fairly in this
manner the prices of monopolized industries without destroying effi-
ciency, the practical difficulties are too great for the exact application
of this theory, - The profit of competitive industries varies from time



1608 DISCUSSION ON VALUATION OF PUBLIC UTILITIES

Mr. to time and from place to place, and that of the various monopolies

■ should vary in the same way. The necessary facts are unknown and

cannot be determined accurately, and the necessary calculations would

be extremely complicated. An enormous staff of regulators would be

required to apply the theory.

The various regulating commissions cannot use this method,
because they have neither the needed facts nor the staffs to gather
them. Therefore, to simplify the method, a tendency toward uniform
profits, where the management is not grossly inefficient, is inevitable.
Regulation is generally only undertaken where there is complaint of
excessive prices, so that the actual regulation is generally extremely
sporadic and intermittent, and it does not follow consistently any
theory, because this is practically impossible. The decisions of the
regulating commissions, therefore, cannot be foreseen, and often appear
to be quite arbitrary.

A very serious consequence of the, at present, extremely indefinite
relations between the natural monopolies and the public is the uncer-
tainty regarding the prices which will be permitted by the regulating
commissions and the consequent large fluctuations in the market values
of their securities. These commissions are directly or indirectly
selected by, and are responsible to, the public, one of the parties to the
implied contract between it and the utility companies. The principal
protection of these companies is the impossibility of securing capital
for new properties, extensions of old ones, and adequate service, unless
sufficient return is allowed on the existing investment. The uncer-
tainty of the return and the fear that it may not be adequate prevent
new investment, unless a large return is allowed to compensate for the
apparent risk. The regulating commissions may fix such prices and
consequent returns as will attract capital and make it thereby possible
to supply adequate public service. Such rates of return may be
thought to be excessive by the public, unless the inadequate service
with lower ones is felt to be the greater evil. Inadequate service,
therefore, may lead to higher rates of return than adequate service, a
condition which is evidently not conducive to the best service. Long-
continued, inadequate service by private companies will create a
demand for a radical change. Unless a way out, which will be an
improvement over present conditions, is made widely known and
adopted, a successful agitation for public ownership and operation
seems to be inevitable. With definite competitive contracts any prac-
ticable and desirable kind of service can be obtained by the public by
paying the necessary competitive price. As most of the risks incident
to arbitrary regulation disappear with definite contracts, investments
in them are comparatively safe, and will attract capital at low rates of
profit. Most of the capital required would be secured by Government
bonds at very low rates of interest.



DISCUSSION ON VALUATION OF PUBLIC UTILITIES 1609

The law ordering the valuation of interstate railways by a Federal Mr.
commission was the result of a widespread belief that the capitalization '*^^^'-
of these roads was largely fictitious and far beyond their cost of pro-
duction. It ordered, therefore, the determination of the actual costs
of production to date and of reproduction less depreciation, so that
they might be compared with the known capitalization, in order to
ascertain the difference between them.

The Committee has done an enormous amount of valuable work to
ascertain the principles for determining these costs and the deprecia-
tion. It has not determined values, however, or the correct prin-
ciples of valuation. What it calls tangible value is not a value, but
a cost of reproduction less depreciation. In the writer's opinion, the
Committee has not altogether abandoned widespread erroneous views
in regard to the nature of value, though it gives, under value and
market value, correct definitions of value, of price, and of market price.

The identiiication of value and price is harmless, as long as the
value of money remains substantially constant. The corrections neces-
sary with changes in the values of money are a separate problem, not
discussed by the Committee.

The determination of costs meets the demands of the Federal law
prescribing it. The unsatisfactory chapter on "Intangible Values"
attempts to meet the demands of the Courts which insist on the con-
sideration of revenue and market values. With a slight correction,
prescribing the addition of what the Committee calls tangible value,
and of intangible value to obtain the total value, its valuation is
correct. The demands made by the nature of economic phenomena,
which prescribe the highest laws to which all others must accommodate
themselves, however, are but imperfectly met by the investigation of
the Committee. The value of an industrial enterprise of any kind
is the present value of its future earnings. Security quotations, where
available, give the fluctuating opinion of the market on the value of
the securities. There are often no reliable quotations; the estimated
future earnings with a fair regulation furnish then the means of de-
termining values.

For determining what is a fair regulation, costs and depreciations
must be ascertained. The Committee has given the principles which
must be followed in determining these, and has thereby done part of
the work necessary for a correct valuation, but it has not given the
principles which must be followed in a real valuation based on revenue
and quotations. The task which is now being performed by the
Federal Commission for Valuation is, in reality, a cost determination
and not a valuation, which latter will not be attempted. The Com-
mission thereby conforms with the spirit and real purpose of the
Federal law. Its work will be very useful in improving present methods
of regulation of public utilities, but will be inadequate for valuing them.



1610 DISCUSSION ON VALUATION OF PUBLIC UTILITIES

Mr. W. R. McCann,* Assoc. M. Am. Soc. C. E. (by letter).— It is

'^' '^"°' readily to be conceded that the Committee has produced a very cred-
itable and momentous work. The task of developing any sort of
unanimity from the chaos which has heretofore existed in matters
pertaining to the valuations of railway and other public utility prop-
erties is an estimable performance that is . appreciated best by those
who are daily engaged in valuation work. The Engineering Profession
as a whole, and particularly those members thereof who have to do
with appraisals of public utilities, owe a sincere debt of gratitude to
the authors who, by exhaustive research and by many conferences,
have succeeded in producing a report which purports to represent and
reflect the Committee's unanimous, composite idea of valuation
theories. Such a report will carry great weight indeed, in the future,
whenever it is quoted and referred to as an authority; and its two
hundred pages will be fingered many times by youthful engineers,
apprenticing in appraisal and valuation work. The extended scope
of the report, and the important utilization of its contents, should
render engineers quite cautious in concurring indiscriminately with
all the statements and theories therein, even though advanced unani-
mously by the Committee.

It is not to be expected that the Committee could produce a report
which would be generally approved by the Society's membership. It
is much more probable, judging from controversies which have arisen
over the subject matter in the report, that every statement therein
has its opponent. The question is, "Does the Committee's report
on valuation of public utilities reasonably represent the status of the
art to-day?" The writer believes that the question must be answered
in the negative, particularly from the point of view of the regulatory
bodies and the judiciary, which are charged by statute with estab-
lishing equities between utility companies and their consumers.

In a great many respects, the report is quite favorable to the
positions heretofore taken by corporations. A careful study of it
makes manifest the conclusion that hardly a scrap of a claim which
will result in enhancing the value of utility property is neglected,
unless it is obvious, alter many a try-out before commissions and
Courts, that the claim manifestly is to be disallowed. There is
great danger in following the report implicitly; young appraisers and
students, particularly, may be led astray, Avith the result that they
may recommend (often advocate) absurd conclusions derived from
adhering too strictly, without the exercise of mature judgment, to
the Committee's leanings.

To point out all the places wherein there is much more to be said
in behalf of the public's side than has been stated by the Committee
would consume as much space as the report itself, and even more.

* Washington, D. C.



DISCUSSION ON VALUATION OF PUBLIC UTILITIES 1611

Such extensive purpose is not the writer's intent in this limited dis- Mr.
cussion; he will confine his remarks to one important subject, that ^*^^^"°"
of ''Original Cost to Date" — a matter which has been given but five
pages, as contrasted with about a hundred pages (nearly one-half of
the entire report) given to the antithetical theory, the "Cost of Ee-
production."

It is to be frankly conceded that much of the language of the
Courts to date has been favorable to the reproduction theory of
valuing utility property; and it is also opportune to remark that a
considerable portion of the judicial language has been misquoted,
misrepresented, and misconstrued by partisan advocates. It is not to
be overlooked, moreover, that the strength of original cost is to be
found in connnission decisions; and this is especially significant in
that those who devote their entire time to the solution of valuation,
rate-making, capitalization, and other problems affecting public
utilities have marked leanings toward the equities inherent in the
original-cost method of valuation. In the writer's opinion, the day is
not far distant when the Courts, on review of a record which contains
a commission decision embracing a valuation based on a properly
compiled original-cost appraisal, will comment much more favorably on
the original-cost method than they have on divers reproduction theories.

Heretofore considerable discredit has been given the original-cost
method, due to confusion which has existed as to what is meant thereby.
The capital account carried on a utility's books has been taken to
mean the original cost of the property; likewise, it is argued that the
purchase-and-sale price in a trade consummated years after the original
construction represents the original cost of the property; also, the
original sum invested in the nucleus of a property has been assumed
to be representative of the original cost. These are not correct
definitions. A proper original-cost appraisal is as capable of precise
definition as is any reproduction theory. Before proceeding further
with this discussion, it is well to bring out what constitutes a sound
original-cost appraisal.

The California Railroad Commission,* submits the following defini-
tion of the term "original cost" :

"The term 'original cost' means the actual expenditures chargeable
to capital account, in accordance with the Interstate Commerce Commis-
sion's or this Commission's classifications, in cash or its equivalent in
terms of cash, by the public utility for its property in the State of
California, as of the date of the valuation."

Mr. Hammond Y. Hayes, f a consulting engineer of Boston, defines
actual original cost, thus :

"The actual original cost is the sum of money which was expended
by the undertaking for the property now in use for the benefit of the

* Annual Report for the fiscal period from July 1st, 1915, to June .30th, 1916, p. 92.
t " Public Utilities : Their Present Fair Value and Return," pp. 123-124.



1613 DISCUSSION ON VALUATION OF PUBLIC UTILITIES

public. It is not what the original property cost but rather what the
present property cost. The expression 'original cost' is liable to convey
a false impression. What is required in a valuation is the 'actual
cost' of the property now in use. The term 'original cost' has been
used so generally in decisions of courts and commissions, however,
that it cannot be now eliminated. * * *

"The actual original cost should not be considered to be the cost
of the first unit of plant used in a particular place or for a particular
purpose. Items of perishable property, which are no longer in use or
useful, cannot be considered as a portion of the property to be in-
cluded in a valuation for the purpose of determining the fair value
for rates. Such items of property have passed out of existence and
their cost should have been removed from the books of the company
as a portion of the value of its assets. If the business of the under-
taking had been conducted properly, reserves for renewals would
have been made. These reserves are obtained from users as a portion
of the charges paid for the service. Manifestly it is unfair to the
users for the company to demand from them rates sufficiently high
to create a fund for the replacement of obsolete items and then include
the cost of such obsolete items in a new value upon which new rates
should be based."

Mr. Robert H. Whitten,* of Brooklyn, likewise defines actual
original cost :

"Strictly speaking, actual cost means cost of original construction
plus cost of additions and betterments. It excludes all expenditures
for renewals and replacements including supersession diie to obsoles-
cence or inadequacy. It includes only construction, additions and
betterments that are a proper capital charge under approved accounting
principles. This conception of actual cost, however, is one that has
in the past been very imperfectly comprehended. Correct accounting
principles are of comparatively recent acceptance and application. The
references made by courts to actual cost or original cost plus improve-
ments show that in most cases they have loosely interpreted the term
to include many things that are not properly a part of the actual cost
of the present property. In certain decisions it is apparently assumed
that actual cost or original cost includes discount on securities issued,
exorbitant profits to promoters, cost of replacing worn-out or super-
seded property, dividends paid out of capital, money sunk in unsuc-
cessful experiments. That is, the term is considered as an equivalent
to book value inflated by financial manipulation or loose accounting.
Considered in this light, it is little wonder that 'original cost' has
been discredited as a standard of valuation.

"Actual cost properly considered is the most natural and in many
. respects the fairest single basis for the determination of fair value
for rate purposes. A fundamental principle of public service regula-
tion is that as the public service corporation devotes its property to a
public use it may consequently be required to render the service at
reasonable rates of charge. Rates of charge to be reasonable may not
be in excess of the fair value of the service and may not be higher
than necessary to produce a fair return on the property devoted to
* "Valuation of Public Service Corporations," pp. 82-83.



DISCUSSIOJ«r ON VALUATION OF PUBLIC UTILITIES 1613

a public use. The measure of the property devoted to a public use Mr.
is undoubtedly, in the first instance, at least, the money that the ^cCann
company has actually and necessarily invested, i. e., the actual cost."

Mr. Halford Erickson, ex-Chairman of the Wisconsin Railroad
Commission, in a paper entitled "Depreciation and Its Relation to
Fair Value", read before The Utilities Bureau in November, 1915,
•comments similarly on the definition and application of an original-
cost appraisal, as follows :*

"By original cost in this connection it seems to me should be
understood the cost at which the existing property used by public
utilities in rendering service was acquired. By cost of reproduction
is meant the cost of reproducing the existing property under pre-
vailing conditions. The original cost of the existing property should
be shown by the books and records of the utilities provided these have
been properly kept and are still in existence. Wlien the books have
not been so kept or are not available, the original cost as thus out-
lined may be determined very much in the same manner as that in
which the cost of reproduction is found. * * *

"When the original cost of the existing property is desired it
can be computed upon the same inventory as that used in determining
the cost of reproduction and upon prices which cover the period when
the property involved was put into the plant. Such price lists may be
had partly from the records of the plant and partly from other sources.
In this way the original cost of the existing property can be had with
even greater accuracy than the cost of reproduction."

The following statement of the Committee (page 1355) follows the
identical line of reasoning, to wit:

"As original cost to date, with comparatively few exceptions, is
not the book cost of the property but the cost of the existing items,
it will be necessary as a rule to make a schedule of the various existing
property items, in the same way that one would be made for deter-
mining the cost of reproduction; then reference would have to be
made to the accounts, to ascertain the unit costs of the items."

The term "Original Cost" is used by the- Engineering Department
of the State Public Utilities Commission of Illinois to mean the actual
expenditures, in cash (or its equivalent in terms of cash), made by a
public utility for used and useful property which is properly charge-
able to capital account and is embraced in an actual inventory;
or, in the absence of records and books of accounts showing the actual
expenditures, the estimated cost of the property as of the sundry dates
of the installations of the various items of property is to be con-
sidered the original cost thereof.

Bearing in mind the aforesaid definitions of what constitutes a
reasonable original-cost appraisal, particularly the definition set up
in the preceding paragraph, it is well to refer to certain passages
* The Utilities Magazine, 1-3-113.



1614 DISCUSSION ON VALUATION OF PUBLIC UTILITIES

of the report, wherein the strict reproduction theory is modified and
violated in principle, and recourse is taken in effect to the original-cost
method. Perusal of the report, moreover, would seem to indicate that
the principles of a pure reproduction theory are adliered to whenever
it is to the general advantage of the property under consideration, and
that historical reproduction cost (another name for an enhanced
original cost) is resorted to whenever the strict reproduction theory
fails to give the "top-notch" figure, or fails to arrive at the known
original cost.

The first specific example wherein the Committee recommends a
departure from the strict reproduction theory, in favor of the
historically modified reproduction theory, is found on pages 1363 to
1765 (inclusive) of the report. Here there are cited instances of
three different dams and reservoirs which were built under entirely
different circumstances respecting contingent and aioxiliary costs. The
Wachusett Reservoir required the obliteration of several buildings,
highways, railroads, and other property formerly on the present reser-
voir site. The Kensico Dam, built within the limits of an existing
reservoir, required the construction of two temporary reservoirs to
maintain a water supply. The Au Sable Dams were constructed under
simple circumstances, unaccompanied by exceptional costs of damages,
removals, or temporary works. The Committee asks if it is fair,
for the reasons stated, "to assume like conditions to govern the estimate
of reproduction cost to be used as a basis of 'fair value' ".

It certainly is apparent that these three dams and reservoirs are
not to be appraised under "like conditions." The strict reproduction
theory, however, calls for an appraisal of the existing property as it
is to-day. Such a premise is satisfactory, say, for the Au Sable Reser-
voir, which did not encounter any unusual auxiliary costs during its
construction. The strict reproduction theory, however, will not pro-
duce sufficient value for the Kensico and the Wachusett Dams; there-
fore the Committee, following in the footsteps of experts who have
forsaken and modified the strict reproduction theory, "is of the opinion
that all such items of cost, due to damages, destruction of property,
purchase of rights, and temporary works, as cited in these illustrations,
are clearly proper items to be included in the reproduction estimate
when capable of historic proof", and this despite the fact that original-
cost appraisals of these dams would reveal, in a very few items, the
exact total sums expended in each of the three works.

It is not amiss at this point to contrast the proposed historical
reproduction method, advocated by the Committee, with the original-
cost method defined hereinbefore. In the Wachusett Dam, for instance,
the appraiser must make a complete survey of the dam and reservoir
as it is to-day; then he must apply unit costs of labor and material



DISCUSSION ON VALUATION OF PUBLIC UTILITIES 1615

at prevailing prices to-day. Thus, the appraiser derives the repro- Mr.
duction estimate of the existing structure, whereupon he starts to *^cC^"°-
conjecture what may have happened during the years of construction.
Imagination is brought into full play in picturing the day-by-day and
month-by-month changes in the scenery before him — once an indus-
trious valley, teeming with activity, possessing thriving railroads, and
incrusted with dust from many roads, now simply a peaceful lake.
Many things might have happened during this transformation, and
therefore the appraiser is restrained in his imaginative process to
what actually did happen. The records of the work must be consulted,
inasmuch as fascinating conjectures must be proved before commis-
sions and Courts. Should the appraiser wander very far from the
recorded facts and the actual cost thereof, he is in difficulties, if a
keen counsel cross-examines him thoroughly as -to the details under-
lying his theory. How much simpler it is to set forth the book-recorded



Online LibraryAmerican Society of Civil EngineersTransactions of the American Society of Civil Engineers (Volume 81) → online text (page 146 of 167)