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Popular Science Monthly/Volume 86/February 1915/The Ethical Principle in Physical Valuation for Rate Making

< Popular Science Monthly‎ | Volume 86‎ | February 1915

THE ETHICAL PRINCIPLE IN PHYSICAL VALUATION FOR RATE MAKING
By E. W. JAMES

OFFICE OF PUBLIC ROADS, U. S. DEPARTMENT OF AGRICULTURE

THE history of the control of public service corporations in this country is very short, but its interest is great enough to warrant even now a historical monograph of considerable length. Though the movement toward governmental control is new, it has been rapid. It culminated about a year ago in the passage of a law authorizing the Interstate Commerce Commission to make a valuation of railroads under its jurisdiction. Physical valuations have been provided for in Wisconsin, Nebraska, Washington, Massachusetts and other states. In general, the state valuation laws, as, for instance, that in Nebraska, provide for the valuation of practically all public service corporations. When we consider the history of corporations in the United States, the adoption of this policy with a view to control of public utilities appears logical enough, and opens a new field of discussion. Some parts of our railroads are eighty years old. Many were built under unusual conditions. The early days of many public service corporations display a tangle of promotion, corruption, lease, combination, purchase and reorganization. Original records in many cases are lost. As a result, the discussion of physical valuation has been largely confined to consideration of the ultimate, technical details of some practicable method, to the neglect of important underlying principles. Valuation has been usually argued from the point of view of the material interests of the disputants. It has been only within the past two or three years that really serious conclusions have been arrived at; and the discussion since the passage of the Physical Valuation Act affecting the Interstate Commerce Commission has alone provided some basis for a formulated set of principles around which interest now centers, A small vocabulary of technical terms has developed in the course of the debate as to principles and methods.

There is an aspect of valuation that has not received the emphasis it deserves. A study of the economic and social phases of the subject may be made much more illuminating than it has been. It appears that such a study would provide a solvent for several of the problems now in dispute among writers of undoubted ability and experience. In the first place, the public attention has not been directed toward corporation control because it had nothing else to busy itself with. The movement toward physical valuation is not an erratic one. The public's point of view has of late years been changing. People are seeing that they have an interest in public service corporations different from that concerned merely with securing good gas, steady current, accommodating trolley service, or pure water. The new laws providing for physical valuation as a basis for determining rates for the use of public utility products or services are an evidence of this change of attitude.

That the public, the user, has been slow to recognize his real interest in public service corporations does not in the least lessen the rightfulness of that interest, or its substantial basis in fact. A savage has little or no ethical life; for although an ethical principle may be absolute per se, the strength of that principle applied depends on contributory circumstances of a nature to compel its recognition. Circumstances of corporation growth, the misuse of the power flowing from privileges granted to individuals by public official bodies, have at last forced the user of the public utilities to recognize his ethical right to consideration.

The interest of the user in the public service company is, of course, first of all, material. The company furnishes some service necessary to health or to the reasonable comforts of modern life, or something necessary to business. These services can not generally be secured except from the public service corporation. For this reason the corporation is looked upon rightly enough as a quasi-public organization. It is no longer a private affair. It is not like the corner grocer or apothecary, who has a competitor on the next corner to whom the customers can go. It is not like the butcher, who has his stall in the public market in a row of twenty similar stalls, and who competes for trade among the passing throng. The public service corporation has, in great degree, the character of a monopoly. The quasi-public element in the public service corporation is recognized originally and conclusively by the grant of any franchise carrying special privileges or providing for exclusion of other similar corporations.

In addition to this material interest, arising in the need of the community for fresh and pure water, light, heat and transportation, there is the other, deeper consideration spoken of above. This flows from the material interest, and is best described as an ethical interest. It is not merely by equity or expediency that the user has rights in public service utilities. It is because he puts something into the business. What he puts in is fixed capital; he can not withdraw it, and heretofore has had little or nothing to say regarding the management of his share of the investment. Much of this fixed capital, owned by the user of the public service utilities, is in the form of franchise privileges granted by the user, through his representatives in the local legislative body, for a period of years or in perpetuity. It is just as surely a vested interest as the money of the bond holder which has laid rails or strung wires, dug ditches or erected pumping stations and gasometers. The fact that the consumer turns the management of his interest in the business over to the other party, together with the fact that when once these contributions are made they can not practicably be withdrawn, establishes the right of the user to fair treatment at the hands of the public utility company. Still stronger appears the user's right to fair treatment when it is considered that he is, in the very nature of the case, the residual investor. That is, under any plan to establish such rates as will provide a "fair return" to the money investor, the user must hold himself ready at any time to meet all demands for financial support involved in the operations of the utility. The user may not provide additional money capital in the early years of development, and may never indeed do so. But if such becomes necessary, the user must, as will be seen, assume the burden of interest charges created by the required borrowing. Mutual obligations between the user and the producer follow naturally as a result of mutual interests. These obligations are as binding on one as on the other. Responsibility for fair treatment has in the past rested with the producer exclusively, because he has occupied the position of control. Unfortunately, the user has not been convinced by the treatment that he has received that his rights have had the recognition they are entitled to. The present movement has resulted, and the relative obligations of both parties are now very generally understood. The investor and producer must be secured in an adequate, "fair return" on his investment. The investment does not necessarily include all the money spent in creating the utility. It is no part of the user's duty to secure to the investor a return on funds spent unwisely, unnecessarily or in any improper way. For instance, construction work might have been done and paid for at an exorbitant rate. It later might develop that the officials in charge of construction were materially interested in the contract and had paid for work at unwarrantable prices because it was to their own advantage to do so. This is the simplest case. More involved ones have not infrequently occurred having essentially the same result. Such expenditures are not wise or necessary by any means, and the user is not bound to recognize them as a part of the investment on which the producer is entitled to a "fair return."

The chief right of the user is to receive efficient service at a rate as low as possible consistent with the right of the investor to receive his "fair return." It is the obligation of the producer to see that this service is provided at a "fair rate" consistent with the conditions under which the public utility is expected to operate. It is the consciousness of these mutual obligations that is the basis of laws restraining public service corporations. The user has seen his investment exploited for the benefit, not of himself, but of the producer. The capitalization of anticipated profits, stock dividends, unduly large underwriting fees in effecting combinations, common "watering" of stock, manipulating and speculating in the securities of public service companies, have all operated in most cases to the disadvantage of the user, the co-investor in the concern. Legal relief has been the obvious remedy sought, and if it has seemed arbitrary, such a condition is only natural as a kind of reaction against the formerly very loose check set upon the conduct of the producer.

It is generally agreed now that a common ground of adjustment has been reached, and that by making a physical valuation of the property of the producer, it will be possible to fix the "fair rate" that is consistent with a "fair return" to the producer under the conditions of operation required of the public utility under consideration.

The details of physical valuation are involved and numerous. Much discussion has taken place, and it continues from week to week in the press and in the courts. Very excellent authorities are at difference with each other on essential points. The difficulty appears to reside in the fact that a common basis in principle cognizant of the interests of the public and of the producer can not be found by those attempting to establish the methods of physical valuation. The first point that must be understood is that a public utility property shall no longer be speculative in character. This is the obvious result of the recognized obligation on the part of the public—the user—to assure the producer a "fair return" on his investment.

The returns on the public service utility investment are, under the plan proposed, to be made fair and equitable by establishing such a rate for the service that the "fair return" will be reasonably assured. This removes the utilities stock from the speculative class. Further, if there remains a speculative element in the utilities stock, it would be an indication of necessary readjustment of "fair rates" to "fair returns."

We are now ready to consider some large details of a physical valuation which are illumined by the principle outlined above; namely, that the user has a right in the properties of the public service utilities; that this right rests on the investment of certain valuable contributions necessary to the operation of the utilities; that flowing from these rights is an obligation that the investor shall be assured a "fair return" on his investment.

If records were complete, the ideal method of arriving at the investment of the investor of funds would be at hand. In some cases it will doubtless be found that such records are complete. Where they are not, the obvious course is to reproduce the actual conditions under which construction was advanced, and estimate the original cost of the properties. There is little difference of opinion that cost of surveys, preliminary studies and investigations, and underwriting and promotion charges which are wise, necessary and reasonable, should be allowed. What shall determine reasonableness in this case is open to debate, but we have some checks. We know that the ordinary commission on stock transactions is one eighth of one per cent. Six per cent, is considered a fair return on investments free from unusual risk. Here, then, are upper and lower limits that may be considered reasonable for underwriting and promoting. The excessive commissions occasionally taken in promoting industrials are certainly unwarranted and should no longer be allowed. In valuating past performances of this kind, and allowing for due risks in the original scheme, it is doubtful if a greater promotion charge should be recognized than would be just and fair to-day. The fairness of this will further appear when we consider deficits and their place in valuation for rate-making purposes.

There is little or no dispute over the valuation of large single elements of the properties until we come to land. Here we meet the first troublesome detail of the subject. The question of land values has puzzled almost every commission to whom has been assigned the physical valuation of utilities. The chief point in dispute is the place of unearned increment. There is no doubt that the actual cost to the company of the land that had to be taken should be allowed. If the cost is a matter of record, it should be taken. This cost should include the necessary severance, damage, transfer and legal charges connected with taking the land. In most cases the records do not exist, and an approximation is resorted to involving the use of a factor to be applied to the present market price of adjacent land. In any case, however, the principle to be followed prescribes that the actual net cost of acquiring the land at the time it was purchased shall be approximated as nearly as may be. To this nothing should be added to represent the increased value since acquisition. This statement is most vigorously combatted by some, but its justice and fairness will, I believe, be made apparent.

The principal argument to support the inclusion of the unearned increment is that the public service corporation should not be denied advantages that flow to all the surrounding land holders. If a valuation were being made for sale, taxation or rental purposes, the inclusion of the increment would be right. But a valuation for rate making should not include it. In the first place, it is only a potential value. A homesteader can not live on his land, develop and use it, and at the same time realize a return on its unearned increment. He has to sell or rent to secure the advantage of it. If a utilities corporation chooses to rent or sell, it doubtless is entitled to take advantage of the unearned increment, if it can find a purchaser on such terms. Further, the unearned increment of the land does not represent an investment of the producer but of the user. The increment arises from the development of the land contributory to the railroad. It is greatest in sections where the development is greatest. It is in essence a contribution of the community. The community is nothing more nor less than the user in an aggregated form, and, as we have seen, the user is a co-investor with the producer in public utility properties. Obviously no part of the return on the user's investment should be included in a "fair return" to the producer. It follows, of course, that lands donated, whether by a person, by a commercial body, or by a government, should not appear in the valuation at all.[1]

An objection might be raised in the case of a utility comprising several smaller properties obtained by purchase. It is probable that the existing corporation paid prices for the land involved that were determined by the current prices of adjacent land at the time of purchase. These included the unearned increment to date. This increment should not be included in the valuation of' the combined properties for rate making purposes. If the purchasing investors were willing to agree upon a price including any part of the unearned increment to date of purchase, they were in the place of a man who, to secure a valuable property of forty acres, buys up four ten-acre places. So long as the purchaser uses the forty-acre place himself he gets no return on the unearned increment, except that flowing from increased enjoyment, a better outlook, or more freedom of action. He recovers that portion of the purchase price invested in unearned increment, with or without interest, when he sells. If he never sells, he never recovers it; and moreover, he loses interest on the investment. If a corporation makes such terms, the users can not fairly be required to pay a return to investors on values contributed by the community. The profits of the investors reside in the continuing increment, if such there be; and they can be taken only at the time of sale. It may be that the whole transaction, involving the purchase, holding and sale, does not show a profit. This may frequently occur; but it is no reason why the public—the user—should be compelled to assume the responsibility of guaranteeing such profits. Some transactions are bound to show loss.

One very remarkable contention has been made in connection with the valuation of land. Stated in its simplest terms, it is this: If a utility has secured the land necessary for its activities, this land should be given a value determined by the advantage residing in it above that afforded by the next less desirable land usable for the operations desired. For instance, if a railroad has located in a very desirable pass, the value of the land in the pass should be determined by the saving in expense both in construction and operation over the next possible location in that vicinity. This argument needs no further attention.

Let us now apply this principle of user's investment to the question of depreciation. This is the next important ground of dissention among writers on the subject of valuation for rate making. It is sometimes held that depreciation should be deducted from the original cost as reproduced. Whether valuation, up to the point of considering depreciation, has been according to the method of cost-new or not, it is quite clear from a statement of the principle of user's interest that depreciation should not be deducted. If an assumed case is considered, this will be seen at once. Suppose a public utility has been paying all obligations, meeting all charges for operation, repair and maintenance, providing annual allotments to such amortizing funds as may be practicable, and making a "fair return," and no more, to the investors, at any rate whatever to the user. Providing there has been no accumulation of surplus, the utility has been doing no better than should be expected of it. Suppose now that owing to any cause at all, maintenance can not be such that depreciation is checked or offset. Or suppose that elements—really a large part of many properties—that can not be practicably amortized by annual allocations, require replacement. If no surplus has accumulated and no more than a "fair return" has been made to investors, it is apparent at once that the rate to the user has been too low. The user has not been contributing, in his innumerable, continuous, small payments, an adequate part of the cost of operations. We have seen that the user is the residual investor. Indeed, this fact makes his ethical right to consideration particularly strong. The "fair rate" that he must pay is not fixed, but the "fair return" to the producer is first assured, and the user is then called upon to contribute what is required to operate the property. If the user is not compelled to pay a rate sufficient to provide for depreciation and consequent replacements, the funds must be secured elsewhere, and this means that new investors come in to whom there must be paid a fair return on a sum equal exactly to the depreciation.

Before leaving this question of depreciation, it might be well to treat it from an entirely different point of view, in order to establish undoubtedly the fact that it must be met by the user. Dr. L. I. Hewes, chief of economics and maintenance, of the United States Office of Public Roads, has introduced the term "absolute maintenance" in connection with the upkeep of highways. As an annual matter, it is only an accounting term. It can not, in most cases, be practically applied each year, for it means maintaining the road in its originally improved condition without deterioration. It includes the charges for resurfacing that occur at the end of a period of years. These charges are distributed equally over the years since construction or last resurfacing, and, together with the annual charges for ordinary repair and maintenance, constitute the annual absolute maintenance charges. There can be no depreciation charged off against the property if an absolute maintenance charge is made.

The conditions under which public service utilities operate demand that they be absolutely maintained.[2] Obviously, it is from gross receipts that all maintenance charges must come. It is financially unsound to use investment funds merely to maintain, and if the user is rightly expected to pay a rate that will, after meeting the "fair return," straight operating expenses, interest, taxes, etc., provide a balance sufficient absolutely to maintain the property, that means that there can occur no depreciation to be deducted, and if annual maintenance charges are less than absolute, and depreciation occurs, it is not to be deducted, because the user has contributed less each year than he rightly should. He has been postponing a part of his payment.

If the depreciation is not taken care of by the user, then the producer may relinquish a part of his "fair return" in order to provide for replacement, and we find our depreciation producing a deficit. We are now ready to consider another controverted matter, called sometimes the deficit theory.

This problem can be attacked in exactly the same manner as depreciation, keeping always in mind our ethical principle, which involves the user jointly with the producer as parties having material interests and mutual obligations in the conduct of public service utilities. In establishing the justice of the deficit theory, the fact previously stated, that the user is the "residual investor," is of greatest force. If business under the usual conditions of developing enterprises is insufficient to meet all operating charges, pay interest, taxes and insurance and furnish a "fair return" to the investor, under practical conditions existent, a deficit is the result. As rates could not, as a practicable measure—and can not, even under the system projected—be adjusted during the development period so as always to produce sufficient gross revenues to meet all demands, the user can not, from his own contributions, provide the necessary further funds. His managers—the producers—either advance the funds for him, or, in other words, forego a part or all of their "fair return," or secure such advances from outsiders. In either case, the user must assume the interest charges. It is not desirable that funds be secured from outside sources if the accumulated "fair returns" are in themselves sufficient to meet the demand, so generally such sums are foregone by the producers as are necessary to meet all charges, and true deficits are incurred. The user, as we have seen, must assume the interest charges on additional funds, if such are secured from outside. Similarly, he must assume the interest charges in the shape of a "fair return" on the deficits covered by the producer. The plain way to accomplish this end is to include in the valuation for rate making the accumulated deficits to date.

We must not stop at this point, however, in our discussion of deficits. The principle we are applying stands for fairness above all things; it is ethical in nature, recognizes rights and obligations which are mutual. If a public service corporation has in the past paid huge dividends, made distributions of stock, and then continued to pay dividends on these paper values; or if future profits, speculative values, have been capitalized and a return made on this capitalization, we are in the opposite position from that involved in the accumulation of past deficits. Early deficits incurred in the development period may long ago have been wiped out. Perhaps surplus funds have accumulated and extensions been made to the original property. In this case, the situation is just as clear as in the former. The returns over and above accumulated past deficits plus a "fair return" should be deducted from the cost-new. In this case the producer has taken more than his "fair return" in the past; the user has contributed more than his "fair rate." An adjustment could be made by having the producer disgorge, but this is not practicable, and the simple and obvious procedure is to permit the producer to retain what he has received, which assumably bears him interest, and deduct it from that capital sum on which the user is to provide a "fair return" in the future.

We are now in a position to discuss surplus, and it will afford another basis of attack on the problem recited just above. Surplus is more easy of definition than most of the elements we have been dealing with. It is the remainder of gross receipts after operating charges, including taxes and insurance, absolute maintenance charges, interest charges, and a "fair return" to investors, have been met. If it exists, it can belong to but one party—the user. The producer should have no benefit from it. The user is the residual investor, the "fair rate" is the dependent function, the user is called upon to make good depreciation, deficits, and to provide a "fair return." But if a surplus is accumulated, the user at last finds something that returns to him. Either the "fair rate" is subject to adjustment, or else the user can accept—and usually would do so under practical conditions—extensions and improvements in the utility. These added values should produce no increased returns to the producer.

If now we apply these principles to the conditions supposed above, involving past unduly large returns to producers, we find that had the parties concerned—the user and the producer—recognized their mutual rights and obligations, and, in consequence, had none but "fair return" been paid to the producer, there would have resulted a large accumulated surplus. As we have seen, this belongs to the user, and if the producer has appropriated it, he should return it, or the user should be relieved of his obligation to the producer by an equal amount. Thus is our previous conclusion supported.

In the course of this discussion, the expressions "fair rate" and "fair return" have been repeatedly used. These terms need no explanation for the ordinary reader of the subject, but the ethical principle applied throughout this paper has its effect in establishing the character of a "fair return," and to this we may now apply ourselves.

We have seen that the user is the residual investor, he appears to get the small end, he has no personal voice in the management of his part of the utility properties. These circumstances are directly attendant on the nature of the contributions made by the user. These are in large part community values that have cost the user nothing directly in money, or else they are made in small amounts from time to time, and at least a portion of such small, continuous and numerous contributions go to purchase some immediate return. This position as residual investor means that the "fair rate" to the user is adjusted, with many attending conditions, to provide a "fair return." The community undertakes to guarantee, in some measure, the safety of the producer's investment. This party is protected against depreciation or deficit, and always against the effects of competition. The regulations under which the mutual arrangements exist have a legal status—are a part of the law of the land. Here, then, we have a condition free from large risks. In the development period, returns may be delayed; but the producer is assured that he will not lose, that all such withholdings will be made up to him and become a basis of continual "fair return." This statement of the case at once disposes of the contention that a "fair return" should be above ordinary interest rates. In fact, the beam is depressed on the side of a lower return than customary in private transactions. Certainly a "fair return" should never be greater than that expected from a permanent or long term investment in a property free from unusual risks.

Finally, we are ready to discuss profits. Many writers hold that in addition to a reasonable interest on the fund invested, the fair return should include profits. The unusual foresight of promoters, the great ability of managers, the doubts and dangers of loss in early days, are all recited as reasons why profits should be allowed. But, sticking strictly to our last, and recognizing the principle here stated in connection with valuation for rate making, we find that the foresight of the promoters has been paid for in proper underwriting and promoting charges, the doubts and dangers of loss have been removed when the user assumes the responsibility of providing for absolute maintenance, and the ability of the managing officials has been rewarded in the usual manner and met as a part of operating charges. The producer, in his personified aggregate, is, to be sure, fewer in number than the user in his personified aggregate. But, nevertheless, the producer is not a personality, and nothing is due him for promoting, managing or by way of compensation for hazarding loss.

Further, profits are the basis of speculative activities, and the one thing that must be recognized above all others, and without which no valuation can be made justly or equitably, is that public utilities are not speculative in character. If they become so at any time, the speculative element must be excised ruthlessly and surely.

A point around which much discussion hangs is the character and place of "going concern value." Once we have taken care of absolute maintenance and the deficit theory, together with the accompanying details of surplus and profit, there is nothing left of "going concern." It is an inclusive term to cover matters not fully grasped in the early days of the valuation discussion, and should have no place to-day.

In conclusion, we must admit that in applying any principle to the adjustment of human affairs, the personal element must be recognized. There is always the matter of wise and unwise payments in the construction period; the personal honesty of officials especially during the period of development. What are we to do with the case of a trolley concern that builds to develop a subdivision? If, through greatly facilitated communication, the subdivision prospers, if the promoters of the real estate transaction and of the trolley company are one, if also the real estate deal produces big profits, but the trolley runs at a deficit, what is to be done? It is useless to deny that complications of the most puzzling kind will be found in arriving at valuations for any purpose. Questions innumerable will arise involving equity, the early history and conduct of absorbed utilities, subsidiary companies, and a complexity of others. But if a few basic principles can be established and adhered to; if the courts can be prevented from piling up a mass of conflicting, baseless precedents that will become millstones about the neck of the appraiser; if skilled appraisers are sought; and if the great, the tremendous importance of these valuations and their profound influence on social and economic conditions are recognized, there is a hopeful future for public service utilities, their producers and their users.

  1. Similarly, bonds guaranteed by counties, a procedure not at all uncommon in the southern states in railroad promotion, have no place in a valuation for rate-making purposes.
  2. This does not consider that some utilities work at full efficiency after about 25 per cent, depreciation due to "normal wear," but the argument is not affected, as absolute maintenance must follow from the point at which permissible depreciation stops.