Statutory and regulatory accounting in the electric power industry

Part eight

IN the electricity rate-setting process, there is a tendency for the external auditors to rely heavily or mostly on the Energy Regulatory Commission’s decision regarding the price of electricity that are allowed to be charged by the Distribution Utilities (DU). As such, the focus of audit work is on internal accounting and management controls. Just like any work done by third party consultants or experts, the external auditor would tend to put much reliance on the results of the price-setting methodology and accepts the decision by the regulator on the price to be charged to consumers as sacred and final.

There is a significant risk involved in this audit approach because the risk that material errors may be committed by either the DU or the regulator and, even both—in connivance or independent of each other and, the error may not be discovered because of too much reliance by the external auditor in the statutory process involved.

Furthermore, the rate-setting methodology ensures that the DU is reasonably compensated and, with additional performance incentives built into the process, it is almost impossible for a DU to incur a loss from operations.  Any DU that would suffer operating losses need to be audited carefully to ascertain the reasons for the losses which could be due to fraud, irregularities and inefficiencies.

In addition to these matters that could result in material financial reporting issues in the financial statements and disclosures thereto, there are other areas which the external auditor may consider a significant risk that warrant spending more time or inclusion in the work program. These include:

1.            The Averch Johnson Effect

The Averch–Johnson effect is the tendency of regulated companies to engage in excessive amounts of capital accumulation in order to expand the volume of their profits.

In an article published by John Dutton—an introduction to electricity markets, he writes: “Congratulations! You are a regulated electric utility. You have a guaranteed [i.e., risk-free] rate of return for all capital investments in your rate base, on behalf of your kind ratepayers. Because you are risk-free, investors are happy to lend you money at low rates. Your guaranteed rate of return is consistent with market returns.  How much capital investment do you want to make?”

The answer is, of course, “as much as possible!”

While the example here is silly, it illustrates a fundamental problem with the incentives given to electric utilities. Remember the equation for the rate base—the more capital that the utility builds, the more profit that it earns. As long as a utility can convince the regulator that a capital investment is needed to maintain a reliable power grid, then ratepayers must fund the cost of that capital investment.

The Averch Johnson effect is sometimes called “gold plating,” which is a term implying that too much money is spent on capital. One result of the Averch Johnson effect is certainly that utilities spend too much money, but it does not mean that utilities always spend $2 billion on a power plant that should only cost $1 billion. It does mean that the utility might choose to build a $1 billion power plant when cheaper alternatives might be available.”

2.            DU Violations of Or Non-Compliance With Legal  Laws or Regulations

The effect on financial statements of laws and regulations varies considerably. Those laws and regulations to which an entity is subject constitute the legal and regulatory framework. The provisions of some laws or regulations have a direct effect on the financial statements in that they determine the reported amounts and disclosures in an entity’s financial statements.

It is the responsibility of management, with the oversight of those charged with governance, to ensure that the entity’s operations are conducted in accordance with the provisions of laws and regulations, including compliance with the provisions of laws and regulations that determine the reported amounts and disclosures in an entity’s financial statements.

The auditor is responsible for obtaining reasonable assurance that the financial statements, taken as a whole, are free from material misstatement, whether  due to fraud or error. In conducting an audit of financial statements, the auditor takes into account the applicable legal and regulatory framework.

When a DU violates certain laws or rules and was fined for it, should this fact be disclosed in the footnote disclosures with adequate explanation as to why the DU opted to take a different path? I believe that this should be disclosed irrespective of whether the assessment of the impact is material or not. In the first place, there must be a valid objective for the legal or regulatory requirement which was violated.  Secondly, the determination of whether the impact is material more often than not is difficult to determine and, thirdly, who will assess the objectivity of the DU’s reasons for violation? For a fair reporting to interested parties, legal violations should be always disclosed together with the DU’s justification and let the public or stakeholders decide for themselves if it is acceptable or not.

To be continued

Alfredo  Non is a CPA by profession and a former Partner at SGV & Co. He served as Commissioner of the Energy Regulatory Commission till he completed his term in 2018. He also served as Director and Executive Officer of several private companies and a former professor in Financial Management at the Ateneo Graduate School of Business.