Utility Fair Market Value Appraisals for Rate Setting

Reviewing Utility Fair Market Value Appraisals by Ashley Everette, Pa. Office of Consumer Advocate

Two utility valuation experts shall perform two separate appraisals of the selling utility for the purpose of establishing its fair market value. 66 Pa.C.S. 1329(a)(2) Role of the Appraisal The average of the appraisals determines the fair market value The lower of the purchase price and the fair market value becomes the ratemaking rate base 2 3/18/2025 Add a footer

The ratemaking rate base affects rates in a direct and measurable way Why do we need to look at the appraisals? Appraisals are not formulaic; they are subject to judgement 3 3/18/2025 Add a footer

The appraisals are to be performed in compliance with the Uniform Standards of Professional Appraisal Practice, or USPAP USPAP is standards for appraisals including competitive business valuations and real estate; is not specific to valuing cost-regulated utility business Appraisal Standards Each utility valuation expert shall determine fair market value in compliance with the Uniform Standards of Professional Appraisal Practice, employing the cost, market and income approaches. 66 Pa.C.S. 1329(a)(3) 4 3/18/2025 Add a footer

JURISDICTIONAL EXCEPTION: an assignment condition established by applicable law or regulation, which precludes an appraiser from complying with a part of USPAP. USPAP Exceptions 2018-2019 USPAP Manual, page 5 5 3/18/2025 Add a footer

Asset Purchase Agreement Components of a Fair Market Value Application Customer Notices Licensed Engineer Report of Assets Appraisal Cost Approach Market Approach Income Approach 6 3/18/2025 Add a footer

Purchase price, including any provisions tying the purchase price to the appraisal results What to look for in the Asset Purchase Agreement Rate commitments such as rate freezes or limitations on future rate increases (e.g. Compound Annual Growth Rate, or CAGR restrictions) Guarantees of capital improvements or other investments 7 3/18/2025 Add a footer

The ratemaking rate base determination will directly impact rates in the next base rate case Customer Notice Most of the fair market value acquisitions we have seen are likely to increase existing and acquired customers rates Customers should receive notice of the proposed acquisition and how it may affect their rates 8 3/18/2025 Add a footer

A procedure to estimate the current costs to reproduce or create a property with another of comparable use and marketability. Cost Approach "Approaches to Value." American Society of Appraisers, www.appraisers.org 9 3/18/2025 Add a footer

The acquiring public utility or entity and selling utility shall engage the services of the same licensed engineer to conduct an assessment of the tangible assets of the selling utility. The assessment shall be incorporated into the appraisal under the cost approach required under paragraph (3). Cost Approach: Engineer s Assessment 66 Pa.C.S. 1329(a)(4) 10 3/18/2025 Add a footer

Engineers Assessment: How are asset values determined? Are all assets used and useful? Preliminary Review Does the selling utility have ownership of all assets it is selling? 11 3/18/2025 Add a footer

Cost Approach: OCN: Original Cost New OCNLD: Original Cost New Less Depreciation Commonly Used Terms RCN: Reproduction/Replacement Cost New RCNLD: Reproduction/Replacement Cost New Less Depreciation 12 3/18/2025 Add a footer

Cost Approach: RCN is generally calculated by indexing OCN plant values to translate original costs into present-day costs. Handy-Whitman Index (utility specific) ENR Index (construction index) Reproduction Cost Other indexes (BLS, AUS) for land, communications equipment, etc. 13 3/18/2025 Add a footer

Reproduction cost of some assets calculated by indexing, other assets using an estimate of present-day costs (this increased the Cost Approach result by more than 30%) Cost Approach: Future capital improvements included in the Cost Approach Cost Approach increased for going value i.e. goodwill Issues we have seen Inclusion of developer-funded plant that had not been dedicated to the municipality Double-trending of costs inflates the RCN (see appendix for example) 14 3/18/2025 Add a footer

A procedure to conclude an opinion of value for a property by comparing it with similar properties that have been sold or are for sale in the relevant marketplace by making adjustments to prices based on marketplace conditions and the properties characteristics of value. Market Approach "Approaches to Value." American Society of Appraisers, www.appraisers.org 15 3/18/2025 Add a footer

Value of the Sellers system is determined on a relative basis, calculating ratios of the purchase price/value of other systems using criteria such as these: Number of customers Population of Service Territory OCN OCNLD RCNLD Market Approach Resulting ratio is multiplied by the relative statistic for the Seller 16 3/18/2025 Add a footer

Market Approach: Purchase prices for comparable sales used that are in excess of fair market value Market Approach increased for going value i.e. goodwill Value calculated based on a future number of customers (projected growth) Issues we have seen (Part 1) Purchase price of comparable systems was increased to account for capital improvements the buyer planned to do 17 3/18/2025 Add a footer

Results using a publicly-traded proxy group increased due to customer contributions Market Approach: Speculative growth and risk adjustments applied to market approach result Use of book financial indicators to determine the value of comparable systems Issues we have seen (Part 2) Limited proxy groups (e.g. only other FMV acquisitions in PA) Excluding FMV acquisitions based on their results 18 3/18/2025 Add a footer

A procedure to conclude an opinion of present value by calculating the anticipated monetary benefits (such as a stream of income) for an income-producing property. Income Approach "Approaches to Value." American Society of Appraisers, www.appraisers.org 19 3/18/2025 Add a footer

Discount rate Annual Revenues Income Approach Original Cost vs. Reproduction New Cost as basis for depreciation Annual Tax vs. Book Depreciation Structure and number annual periods in a model Estimation of Terminal Values 20 3/18/2025 Add a footer

Income Approach 25% Appraisal Weightings Market Approach 25% Cost Approach 50% 21 3/18/2025 Add a footer

Ashley Everette Contact Information Pennsylvania Office of Consumer Advocate aeverette@paoca.org 717-783-5048 22 3/18/2025 Add a footer

Appendix 23 3/18/2025

Reviewing Fair Market Value Appraisals Practical Applications 24 3/18/2025

Engineer Appraiser Engineer Cost Trending 1976Cost: 2018 Cost: 2018 Cost: $8.59 per linear foot $51.54 per linear foot $45.60 per linear foot Example: 4 ductile iron pipe, installed in 1976 Calculated by trending the 2018 cost with the ENR Index Calculated by trending the 1976 cost with the Handy-Whitman Index Calculated Using RS Means 25 3/18/2025 Add a footer

Comparable Acquisition: $160 Million Purchase Price 20,000 Customers; RCNLD of $140 Million $8,000/customer ($160 Million / 20,000 customers) Purchase Price/RCNLD of 1.14 ($160 M / $140 M) Market Approach: Seller s System: Simplified Example 1,000 Customers; RCNLD of $6 Million Valuation of $8 Million based on number of customers ($8,000 per customer x 1,000 customers) Valuation of $6.84 based on RCNLD (Ratio of 1.14 x RCNLD of $6 Million) 26 3/18/2025 Add a footer

Comparable Acquisition: Market Approach : Purchase Price $150 M OCNLD $75 M Ratio 2.0 = x Sales Comparison Example Ratio from Comparable Acquisition Applied to Subject Transaction: Valuation Result $80 M OCNLD $40 M Ratio 2.0 x = 27 3/18/2025 Add a footer

Consider whether the claimed OCNLD amount is equivalent to the OCNLD for the acquired system. Comparable Acquisition: Market Approach : Purchase Price $150 M OCNLD $75 M Ratio 2.0 = x Sales Comparison Example (continued) Ratio from Comparable Acquisition Applied to Subject Transaction: Valuation Result $80 M OCNLD $40 M Ratio 2.0 x = 28 3/18/2025 Add a footer

Consider whether the claimed OCNLD amount is equivalent to the OCNLD for the acquired system. Comparable Acquisition: Market Approach : Purchase Price $150 M OCNLD $75 M Ratio 2.0 = x $100 M 1.5 Sales Comparison Example (continued) Ratio from Comparable Acquisition Applied to Subject Transaction: Valuation Result $80 M Ratio 2.0 OCNLD $40 M x = 1.5 $60 M 29 3/18/2025 Add a footer

When multiple comparable acquisitions are used, how is the result determined? Market Approach : Example Acquisitions Purchase Price RCNLD Ratio A $40 million $35 million 1.14 Sales Comparison Example B $150 million $100 million 1.5 C $165 million $80 million 2.06 D $5 million $6 million 0.83 Total $360 million $221 million Weighted Avg: 1.38 Simple Avg: 1.63 30 3/18/2025 Add a footer

Method of Averaging Matters! Simple average of ratios: 1.38 Market Approach : Ratio of 1.38 x Seller s RCNLD $70 M Indicated Value: $97 M Sales Comparison Example (continued) Weighted average: 1.63 Ratio of 1.63 x Seller s RCNLD $70 M Indicated Value: $114 M Weighting the average increased the valuation by 17% 31 3/18/2025 Add a footer

Valuation Issues in the Income Approach Assistance with the Income Approach analysis provided by Glenn Watkins, Technical Associates, Inc. 32 3/18/2025 Add a footer

Discount Rate Issues Income Approach: High equity ratios Returns on equity much lower than those utilized by Commission or those that could be considered reasonable Discount Rate Understated costs of debt 33 3/18/2025 Add a footer

Income Approach: Revenues Revenue assumptions should recognize that the annual revenues will be a function of cost of service under as a regulated public utility Estimated revenues 34 3/18/2025 Add a footer

Income Approach: Basis for Depreciation The income approach is calculated on based on depreciated cost. What is the rate base ? Basis for depreciation 35 3/18/2025 Add a footer

Income Approach: Annual Depreciation: Book vs. Tax When calculating cash flows, tax depreciation is more appropriate to use If tax depreciation is used, consider the following: The reversal of tax over book depreciation in future years should be reflected The use of tax depreciation should be reflected in the expected revenue stream. Determination of annual depreciation 36 3/18/2025 Add a footer

Structure and number of annual periods in a model Water and Wastewater utilities plant investments have relatively long service lives (35 to up to 75 years). Income Approach: Most DCF models used for valuations are much abbreviated with only 13 to 20 years of annual cash flows modeled. Terminal Values In part to reflect the remaining life of plant investments beyond the number of years modeled, terminalvalues are commonly employed. 37 3/18/2025 Add a footer

Terminal Values: to reflect the remaining life of plant beyond the years modeled in the DCF Income Approach: The most common (and inappropriate) method used to estimate terminal values is to apply the last model year s cash flow to capitalization rate. Under the capitalization approach, net cash flows are assumed to grow at a constant annual growth rate in perpetuity without significant reinvestment of existing plant This would require the assumption that the annual cash depreciation levels are greater than the level of annual capital expenditures Terminal Values 38 3/18/2025 Add a footer

(1) Revenue (2) Cash O&M Expenses (3) Depreciation (4) Earnings Before Interest & Taxes $100,000 $1,000,000 $600,000 $300,000 (5) Income Taxes (6) Net Operating Income $35,000 $65,000 Terminal Value Example (7) Capital Expenditures (8) Change in Working Capital (9) Net Cash Flow: (6) + (3) - (7) - (8) $100,000 $10,000 $255,000 Notice depreciation (3) on existing plant in last year is significantly greater than capital expenditures (7) to replace plant. It would be mathematically impossible to sustain a positive level of growth in perpetuity when depletion of plant investment is greater than the replenishment of such plant. 39 3/18/2025 Add a footer