DOCKET NO DIRECT TESTIMONY of DANE A. WATSON. on behalf of SOUTHWESTERN PUBLIC SERVICE COMPANY. (Revenue Requirement) Table of Contents

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1 DOCKET NO APPLICATION OF SOUTHWESTERN PUBLIC SERVICE COMPANY FOR AUTHORITY TO CHANGE RATES AND TO RECONCILE FUEL AND PURCHASED POWER COSTS FOR THE PERIOD JANUARY 1, 2010 THROUGH JUNE 30, 2012 PUBLIC UTILITY COMMISSION OF TEXAS DIRECT TESTIMONY of DANE A. WATSON on behalf of SOUTHWESTERN PUBLIC SERVICE COMPANY (Revenue Requirement) (Filename: WatsonRRDirect.doc) Table of Contents GLOSSARY OF ACRONYMS AND DEFINED TERMS... 3 LIST OF ATTACHMENTS... 4 I. WITNESS IDENTIFICATION AND QUALIFICATIONS... 5 II. ASSIGNMENT AND SUMMARY OF TESTIMONY AND RECOMMENDATIONS... 8 III. DEPRECIATION ANALYSIS PHILOSOPHY IV. SPS BOOK DEPRECIATION STUDY A. SUMMARY OF THE SPS STUDY B. OVERVIEW OF DEPRECIATION STUDY METHOD C. PRODUCTION AND OTHER PRODUCTION PLANT LIFE OF ASSETS NET SALVAGE OF PRODUCTION AND OTHER PRODUCTION ASSETS DEPRECIATION RATE FOR PRODUCTION AND OTHER PRODUCTION ASSETS D. TRANSMISSION, DISTRIBUTION, AND GENERAL PROPERTY LIFE OF TRANSMISSION, DISTRIBUTION, AND GENERAL ASSETS Watson Direct Revenue Requirement Page 1 RR2-383 of

2 2. NET SALVAGE RATES TRANSMISSION, DISTRIBUTION, AND GENERAL DEPRECIATION RATES FOR TRANSMISSION, DISTRIBUTION, AND GENERAL PROPERTY E. VINTAGE YEAR DEPRECIATION OF GENERAL PLANT ASSETS, FERC ACCOUNTS V. CONCLUSION AFFIDAVIT Watson Direct Revenue Requirement Page 2 RR2-384 of

3 GLOSSARY OF ACRONYMS AND DEFINED TERMS Acronym/Defined Term ALG Meaning Average Life Group AR-15 FERC Accounting Release 15 Depreciation EEI Entergy FERC IEEE SDP SPS SPR TESCO Public Utility of Texas SPS Texas Book Depreciation Accrual Rate at June 30, 2013 Edison Electric Institute Entergy Texas, Inc. Federal Energy Regulatory Institute of Electrical and Electronics Engineers Society of Depreciation Professionals Southwestern Public Service Company, a New Mexico Corporation Simulated Plant Record Method Texas Electric Services Company Test Year July 1, 2012 through June 30, 2013 TXU Xcel Energy Texas Utilities Electric Company and successor companies Xcel Energy Inc. Watson Direct Revenue Requirement Page 3 RR2-385 of

4 LIST OF ATTACHMENTS Attachment DAW-RR-1 DAW-RR-2 DAW-RR-3(CD) Description List of Appearances before Regulatory Bodies by Dane A. Watson. (Filename: DAW-RR-1.xls) Southwestern Public Service Company Texas Book Depreciation Accrural Rate at June 30, 2013 (Filename: DAW-RR-2.pdf) Workpapers to SPS Depreciation (Various native and pdf files provided on CD) Watson Direct Revenue Requirement Page 4 RR2-386 of

5 DIRECT TESTIMONY OF DANE A. WATSON I. WITNESS IDENTIFICATION AND QUALIFICATIONS Q. Please state your name and business address. A. My name is Dane A. Watson. My business address is 1410 Avenue K, Suite 1105B, Plano, Texas Q. By whom are you employed and in what position? A. I am a Partner of Alliance Consulting Group. Alliance Consulting Group provides consulting and expert services to the utility industry. Q. On whose behalf are you testifying in this proceeding? A. I am filing testimony on behalf of Southwestern Public Service Company ( SPS ), a wholly owned subsidiary of Xcel Energy Inc. ( Xcel Energy ). Xcel Energy is a registered holding company that owns several electric and natural gas utility companies. 1 Q. Please describe your educational background. A. I hold a Bachelor of Science degree in Electrical Engineering from the University of Arkansas at Fayetteville and a Master's Degree in Business Administration from Amberton University. 1 Xcel Energy is the parent company of four utility operating companies: Northern States Power Company, a Minnesota corporation; Northern States Power Company, a Wisconsin corporation; Public Service Company of Colorado, a Colorado Corporation; and SPS, a New Mexico Corporation. Xcel Energy s natural gas pipeline subsidiary is WestGas InterState, Inc. Watson Direct Revenue Requirement Page 5 RR2-387 of

6 Q. Please describe your professional experience. A. Since graduation from college in 1985, I have worked in the area of depreciation and valuation. I founded Alliance Consulting Group in 2004 and am responsible for conducting depreciation, valuation, and certain accounting-related studies for clients in various industries. My duties related to depreciation studies include the assembly and analysis of historical and simulated data, conducting field reviews, determining service life and net salvage estimates, calculating annual depreciation, presenting recommended depreciation rates to utility management for its consideration, and supporting such rates before regulatory bodies. My prior employment from 1985 to 2004 was with Texas Utilities Electric Company and successor companies ( TXU ). During my tenure with TXU, I was responsible for, among other things, conducting valuation and depreciation studies for the domestic TXU companies. During that time, I served as Manager of Property Accounting Services and Records Management in addition to my depreciation responsibilities. I have twice been Chair of the Edison Electric Institute ( EEI ) Property Accounting and Valuation Committee and have been Chairman of EEI s Depreciation and Economic Issues Subcommittee. I am a Registered Professional Engineer in the State of Texas and a Certified Depreciation Professional. I am a Senior Member of the Institute of Electrical and Electronics Engineers ( IEEE ) and served for several years as an officer of the Executive Board of the Dallas 22 Section of IEEE. I am also currently Past-President of the Society of 23 Depreciation Professionals. Watson Direct Revenue Requirement Page 6 RR2-388 of

7 Q. Do you hold any special certification as a depreciation expert? A. Yes. The Society of Depreciation Professionals ( SDP ) has established national standards for depreciation professionals. The SDP administers an examination and has certain required qualifications to become certified in this field. I met all requirements and hold a Certified Depreciation Professional certification. Q. Have you previously testified at any regulatory commission? A. Yes. I have conducted depreciation studies and filed testimony or testified on depreciation and valuation issues before the Public Utility of Texas ( ), the New Mexico Public Regulation, and numerous other regulatory bodies as listed in my Attachment DAW-RR-1. Watson Direct Revenue Requirement Page 7 RR2-389 of

8 1 2 II. ASSIGNMENT AND SUMMARY OF TESTIMONY AND RECOMMENDATIONS Q. What is your assignment in this proceeding? A. The purpose of my testimony is to: Discuss the recent SPS Texas Book Depreciation Accrual Rate at June 30, 2013, completed for SPS assets ( Depreciation ); and Support and justify the recommended depreciation rate changes for SPS assets for the period between July 1, 2012 and June 30, 2013 ( Test Year ), based on the results of the Depreciation. Q. Please summarize your conclusions regarding depreciation rate changes for SPS assets based on the results of the Depreciation. A. The Depreciation and analysis performed under my supervision fully support SPS s proposed depreciation rates applied to June 30, 2013 depreciable plant balances for Production plant, Other Production plant, Transmission plant, Distribution plant (Texas only) and General Property plant. The Depreciation follows the s long-standing precedent for Average Life Group ( ALG ) straight-line depreciation. In this way, all customers are charged for their appropriate share of the capital expended for their benefit. In order to ensure intergenerational equities, the should adopt the life, interim retirement characteristics, and net salvage parameters proposed in this study. The Depreciation supports a negative five percent net salvage for its Production and Other Production assets, instead of the positive five percent net salvage that is the currently approved rate for SPS. The positive five percent net salvage is not reflective of SPS s recent experience and negative five percent net salvage is Watson Direct Revenue Requirement Page 8 RR2-390 of

9 supported by long-standing precedent. The Depreciation also proposes updated service lives and accounts for increased removal costs for Transmission and Distribution assets in the proposed depreciation rates. SPS s depreciation rates should be set at the levels supported in the Depreciation in order to recover SPS s total investment in property over the estimated remaining life of the assets. Q. How is the Depreciation used to determine SPS s depreciation expense for the Test Year? A. SPS uses depreciation rates determined in the Depreciation to calculate the appropriate depreciation expense for the Test Year. The information presented in the Depreciation is based on June 30, 2013 Test Year depreciable plant balances and all of the conclusions are based on those balances. SPS witness Lisa H. Perkett will discuss the impact of the new depreciation rates on SPS s Test Year depreciation expense. Watson Direct Revenue Requirement Page 9 RR2-391 of

10 1 III. DEPRECIATION ANALYSIS PHILOSOPHY Q. Please describe the depreciation analysis philosophy reflected in the current Depreciation. A. The objective of any sound depreciation philosophy should be the matching of expense with revenue over the life of the asset. In general, the life of the asset is determined by several factors including the rate of physical deterioration, obsolescence, weather, maintenance, or (in some cases) the economic usefulness of an entire operating unit. The function of depreciation is to recognize the cost of an asset spread over its useful life. Book depreciation techniques should not accelerate or defer the recovery of an asset in comparison to its appropriate useful life. Q. What objective should the strive to achieve in setting depreciation rates? A. The objective of computing depreciation is to ensure that all customers using the assets pay their pro rata share for the investment, including the cost of retirement. This objective is achieved by allocating the cost or depreciable base of a group of assets over the service life of those assets, on a straight-line basis, by charging a portion of the consumption of the assets to each accounting period. Q. Is this objective consistent with rules and historic practice? A. Yes. As evidenced by P.U.C. SUBST. R (b)(1)(B) and the s prior rate decisions, the has a long standing practice of establishing depreciation rates using the straight-line depreciation method based on the actual historic data of the utility. The straight-line method of depreciation operates by Watson Direct Revenue Requirement Page 10 RR2-392 of

11 collecting a pro rata share of the cost of the investment, including removal cost, from all customers that use the asset over its useful life. Q. What is the best evidence that the can rely on to ensure that the cost of certain assets are ratably recovered over the service life of the asset? A. The best evidence is the actual experience of the specific group of assets being 6 analyzed. This evidence is found in the Depreciation based on plant investment in service at June 30, Q. What happens when depreciation rates are not adjusted to reflect the actual life and retirement characteristics of the assets? A. When depreciation rates are set at a level that does not reflect the actual life and retirement characteristics of a utility s assets, the cost of the asset will not be recovered on a pro rata basis from all customers that use the asset. For example, in instances where the net salvage rate for certain plant accounts is set at a level that is insufficient under current conditions to recover the cost of the asset, SPS will not accrue a reasonable level of removal cost over the useful life of the plant 16 asset. This, in turn, means that future customers will have to pay a disproportionate share of the removal costs to make up for the payment deferrals. Q. Is the situation you just described at issue in this case? A. Yes. Currently, SPS is using a positive five percent net salvage for its Steam Production and Other Production assets. This net salvage percent was adopted in the Unanimous Stipulation in Docket No and remained unchanged in the 2 In the Matter of the Application of Southwestern Public Service Company for Authority to Change Rates and to Reconcile Fuel and Purchased Power Costs for 2006 and 2007, and to Provide a Credit for Fuel Cost Savings, Docket No (Jun. 1, 2009). Watson Direct Revenue Requirement Page 11 RR2-393 of

12 stipulations in the next two SPS rate cases in Docket Nos and Five percent positive net salvage is neither reflective of SPS s recent experience nor the long-standing precedent of this. My proposed depreciation rates return net salvage percentages to negative five percent net salvage rates for Steam and Other Production plant. Q. What actions should be taken in order to remedy the change in dismantling costs and other changes in life and net salvage? A. The should approve SPS s proposed depreciation rates which more accurately reflect service life and net salvage for SPS s existing assets. The depreciation rates proposed in the Depreciation more accurately reflect SPS s current experience and future expectations and also allow for the recovery of depreciation expense that has been under-accrued in the past. In addition, adoption of the proposed depreciation rates should ensure, going forward, that current SPS customers pay more of their pro-rata share of the investment over the remaining life of the investment. This ensures that future customers are not unduly burdened by having to pay a disproportionate share of any remaining investment balance for removal costs at the end of the asset s life. 3 In the Matter of the Application of Southwestern Public Service Company for Authority to Change Rates and to Reconcile Fuel and Purchased Power Costs for 2008 and 2009, Final Order Approving Stipulation, Docket No (Mar. 25, 2011). 4 In the Matter of the Application of Southwestern Public Service Company for Authority to Change Rates and to Reconcile Fuel and Purchased Power Costs for the Period January 1, 2010 Through June 30, 2012, Docket No (Jun. 19, 2013). Watson Direct Revenue Requirement Page 12 RR2-394 of

13 1 IV. SPS BOOK DEPRECIATION STUDY A. Summary of the SPS Q. Have you prepared a Depreciation for SPS? A. Yes. I undertook a comprehensive analysis of annual depreciation for SPS that is 5 based on SPS s depreciable plant in service as of June 30, The Depreciation analyzed the property characteristics of SPS s Production plant, Other Production plant, Transmission plant, Distribution plant, and General Property plant and proposes depreciation rates for these assets. The study is attached to my testimony as Attachment DAW-RR-2. Q. What depreciation rates are you recommending in this proceeding? A. My recommended depreciation rates for SPS are provided in Appendix A of the Depreciation. Based on updated service life and net salvage rates for SPS s depreciable plant in-service as of June 30, 2013, I derived the appropriate depreciation rates for Production plant, Other Production plant, Transmission plant, Distribution plant (Texas only), and General Property plant. Q. When did the last change in SPS s depreciation rates occur? A. The last change in SPS s depreciation rates became effective on January 1, Those rates were established based on the stipulation agreement in SPS s 2008 rate case, Docket No Under the stipulation agreement, the depreciation rates were the rates recommended by the Alliance of Xcel Municipalities. The 5 Docket No , Final Order at FoF 18.a (Jun. 2, 2009) and Unanimous Stipulation at 4(a). Watson Direct Revenue Requirement Page 13 RR2-395 of

14 stipulation agreement in SPS s 2010 rate case, in Docket Nos and continued the use of the rates implemented in Docket No Q. Did you present a depreciation study in Docket No ? A. Yes. I presented a depreciation study in my direct testimony in that docket. I also presented a partially updated depreciation study in Docket No , but it was not a comprehensive update to my depreciation study in Docket No I did present a comprehensive depreciation study in Docket No However, that case was settled and the existing approved rates from Docket No are still being applied. Q. What has changed since your last comprehensive depreciation study? Some life changes were indicated, but net salvage in most of SPS s assets continues to be much more negative than those reflected in SPS s current depreciation rates for several reasons. First, SPS has decided not to request actual experience and dismantling cost study estimates for all Production plant, but to request the return to its long-standing precedent of negative five percent for all production plant net salvage. The negative five percent net salvage for Production plant and Other Production plant is supported by the dismantling cost study conducted by TLG Services for SPS s 2012 rate case (Docket No ). Using the negative five percent net salvage would be a first step in setting production plant depreciation rates that will stop deferring the costs and aid SPS in recovering from current customers their pro rata share of costs that is currently serving these customers. 6 Docket No , Order at FoF 18.a (Mar. 25, 2011) and Unopposed Stipulation at V(a). Watson Direct Revenue Requirement Page 14 RR2-396 of

15 Second, the removal costs for transmission and distribution plant continues to rise. Life and net salvage were examined for both functions and minor changes in life are recommended. Almost every account in Transmission and Distribution continues to exhibit increased cost of removal resulting in increasingly negative net salvage. SPS s proposed depreciation rates in this case reflect this reality. Finally, SPS seeks to continue use of Vintage Group Amortization for its General Plant Assets in Federal Energy Regulatory ( FERC ) Accounts The only change in depreciation expense in these accounts will come from updated life and net salvage estimates for accounts in that group. B. Overview of Depreciation Method Q. What definition of depreciation did you use in preparing your Depreciation and testimony? A. The term depreciation, as I use it, is a system of accounting that distributes the cost of assets, less net salvage (if any), over the estimated useful life of the assets in a systematic and rational manner. It is a process of allocation, not valuation. Depreciation expense is systematically allocated to accounting periods over the life of the assets. The amount allocated to any one accounting period does not necessarily represent the loss or decrease in value that will occur during that particular period. Thus, depreciation is considered an expense or cost, rather than a loss or decrease in value. SPS accrues depreciation based on the original cost of all property included in each depreciable plant account. On retirement, the full Watson Direct Revenue Requirement Page 15 RR2-397 of

16 cost of depreciable property, less any net salvage amount, is charged to the depreciation reserve. Q. Please describe your Depreciation approach. A. I conducted the Depreciation in four phases, as shown in Attachment DAW-RR-2. The four phases are: Data Collection, Analysis, Evaluation, and Calculation. I began each of the studies by collecting the historical data to be used in the analysis. After the data had been assembled, I performed analyses to determine the life and net salvage percentage for the different property groups being studied. As part of the process for the study I conducted in Docket No , I conferred with field personnel, engineers, and managers responsible for the installation, operation, and removal of the assets to gain their input into the operation, maintenance, and salvage of the assets. Because that process occurred recently, in 2012, that information was also used in this Depreciation. The information obtained from field personnel, engineers, and managerial personnel, combined with the study results, is then evaluated to determine how the results of the historical asset activity analysis, in conjunction with SPS s expected future plans, should be applied. Using all of these resources, I then calculated the depreciation rate for each function. Q. What property is included in the Depreciation? A. There are five distinct classes of property in this study: Production, Other Production, Transmission, Distribution (Texas only), and General Property. The Production Plant functional group consists of all structures, boiler plant equipment, turbogenerator equipment, accessory electrical equipment, and other Watson Direct Revenue Requirement Page 16 RR2-398 of

17 miscellaneous assets used to generate electricity at SPS s gas- and coal-fired power plants. The Other Production function consists of similar assets used at SPS s combustion turbine facilities. The Transmission plant functional group consists of structures, substations, and transmission lines used in the transmission of energy to the distribution system. The Distribution plant functional group consists of structures, substations, transformers, meters, services, distribution lines, guard lights, and street lighting used in the distribution and end use of energy on the distribution system. The General plant functional group contains facilities associated with the overall operation of the business such as land and water rights, office equipment, and computers rather than with a specific transmission or distribution classification. Q. What depreciation methodology did you use? A. The ALG, straight-line, remaining-life depreciation system, was employed to calculate annual and accrued depreciation in the studies for all plant except small dollar item assets found in FERC Accounts The ALG methodology is the same method used in prior studies and has been approved by this in prior dockets both for SPS and other companies within Texas. C. Production and Other Production Plant 1. Life of Assets Q. Please describe the methodology you used to determine life for Production and Other Production plant. A. For Production and Other Production plant, most components are expected to have a retirement date concurrent with the planned retirement date of the Watson Direct Revenue Requirement Page 17 RR2-399 of

18 1 generating unit. The terminal retirement date refers to the year that each facility 2 will cease operations. The terminal retirement date along with the interim 3 4 retirement characteristics of the individual assets that will retire prior to the facility ceasing operation, describe the pattern of retirement of the assets that 5 comprise a generating unit. The estimated terminal retirement dates for the various generating units were determined based on consultation with SPS management, financial, and engineering staff and are shown in Attachment DAW-RR-2, Appendix D. Interim retirement curves were used to model the retirement of individual assets within primary plant accounts for each generating unit prior to the terminal retirement of the facility for all steam generating units. Other production facilities were not modeled with an interim retirement curve. Q. What is an interim retirement curve? A. An interim retirement curve projects how many of the assets or units within a facility that are currently in-service will retire each year prior to the final retirement of the whole facility, using historical analysis and judgment. The life span procedure assumes all assets are depreciated (straight-line) for the same number of periods and retire at the same time (the terminal retirement date). Adding interim retirement curves to the procedure reflects the fact that some of the assets at a power plant will not survive to the end of the life of the facility, but will be retired earlier than the terminal life of the facility and should be depreciated (straight-line) over a shorter time frame to match their projected lives. In this study, we analyzed each account separately to estimate an interim retirement curve for FERC Accounts Assets in the Other Production Watson Direct Revenue Requirement Page 18 RR2-400 of

19 function have very limited retirements, so no interim retirement curve is incorporated for those units. Q. Has the previously reflected interim retirements in depreciation rates? A. Yes. The included interim retirements in Docket No Q. Has the made any recent rulings regarding interim retirements? A. Yes. In the Entergy Texas, Inc. ( Entergy ) rate proceeding, Docket No ; 8 the excluded interim retirements in the depreciation rate computation. Specifically, the found in its Order on Rehearing, Finding of Fact 100, that [t]he retirement (actuarial) rate method, rather than the interim retirement method, should be used in the development of production plant 12 depreciation rates. Also in the Southwestern Electric Power Company rate proceeding, Docket No ; 9 the stated in Finding of Fact 195, [t]he rate at which interim retirements will be made is not known and measurable. Incorporation of interim retirements would best be done when those 16 retirements are actually made. It is not reasonable to incorporate interim retirements, resulting in a reduction in the depreciation expense of $1 million on a Texas retail basis. 7 Application of Texas Utilities Electric Company for the Reconciliation of Fuel Costs, Docket No (Aug. 26, 1997). 8 Application of Entergy Texas Inc. for Authority to Change Rates, Reconcile Fuel Costs, and Obtain Deferred Accounting Treatment, Docket No (Sep. 14, 2012). 9 Application of Southwestern Electric Power Company for Authority to Change Rates and Reconcile Fuel Costs, Docket No (Oct. 10, 2013). Watson Direct Revenue Requirement Page 19 RR2-401 of

20 Q. Do you agree that interim retirements should be excluded in the depreciation rate computation? A. No. It is critical to include interim retirements in the depreciation rate computation. Q. Why is it critical to include interim retirements in the depreciation rate computation? A. Interim retirements model how plant assets are actually retired prior to a terminal retirement of an entire facility. To exclude interim retirements means that in the future all production investment will remain in service for depreciation purposes, until the facility retires, even though some of those assets will be functionally retired. Q. Please give an example of including interim retirements in the depreciation rate computation. A. Consider a plant facility costing $1,000,000 with a 10-year life and negative 10 percent net salvage. In that situation, the accrual rate and capital recovery stream would be as shown below. Chart DAW-RR-1 Year Plant Retirement Accrual Rate Annual Accrual Net Salvage Depreciation Reserve 1 1,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, % 110, , ,000,000 1,000, % 110,000 (100,000) 0 Watson Direct Revenue Requirement Page 20 RR2-402 of

21 1 2 3 If there was an early retirement of 12 percent of the plant facility at age 6, then the capital recovery would be as follows: Chart DAW-RR-2 Year Plant Retirem ent Accrual Rate Annual Accrual Net Salvage Depreciation Reserve 1 1,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, , % 110,000 (12,000) 528, , % 96, , , % 96, , , % 96, , , , % 96,800 (88,000) (52,800) In this situation, the company s assets are not fully recovered, thus creating an intergenerational inequity that must be recovered from future customers. Q. What would be the effect of changing the depreciation accrual rate when the interim retirement occurs? A. If the depreciation rate is changed when the interim retirement occurs, the capital recovery pattern would change to the following: Watson Direct Revenue Requirement Page 21 RR2-403 of

22 1 Chart DAW-RR-3 Year Plant Retirement Accrual Rate Annual Accrual Net Salvage Depreciation Reserve 1 1,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, % 110, , ,000, , % 110,000 (12,000) 528, , % 110, , , % 110, , , % 110, , , , % 110,000 (88,000) Note that the annual accrual rate increases by percent after the interim retirement occurs in order to fully recover the investment in the plant. Q. What would be the recovery pattern if interim retirements were included from the plant s inception? A. The average service life would be modified to reflect an interim retirement. The calculations are as follows. Average service life = (120,000 x ,000 x 10)/ 1,000,000 = 9.52 years. The accrual rate would be (1- net savage percent)/9.52 = 11.55%. The capital recovery stream would be as follows: Watson Direct Revenue Requirement Page 22 RR2-404 of

23 1 Chart DAW-RR-4 Year Plant Retirement Accrual Rate Annual Accrual Net Salvage Depreciation Reserve 1 1,000, % 115, , ,000, % 115, , ,000, % 115, , ,000, % 115, , ,000, % 115, , ,000, , % 115,546 (12,000) 561, , % 101, , , % 101, , , % 101, , , , % 101,681 (88,000) The important point from this example is that unless depreciation rates include a component for retirements that occur during the life of the plant, then the cost those assets will not be fully recovered when the plant is retired. Failing to address the reality of early retirement violates the matching principle and creates intergenerational inequity when assets that are retired and replaced over the plant s operation are not recovered during the plant s life. Additionally, reflecting the earlier retirements during the life of the assets allows the depreciation expense for all generations of customers (all else being equal) to be based on the same depreciation rate. Q. Have all production assets for SPS that have been placed in service remained in service until the plant finally retires? A. No. From , SPS has retired approximately $208 million in assets in the production function prior to final plant retirement. That is approximately 12 percent of the plant in service in production for FERC Accounts as of June 30, I recommend the re-evaluate the interim retirement Watson Direct Revenue Requirement Page 23 RR2-405 of

24 issue in this proceeding. The depreciation rates I propose for SPS production assets incorporate an interim retirement curve model that recognizes the reality that some assets will retire prior to plant retirement date. 2. Net Salvage of Production and Other Production Assets Q. What is the significance of net salvage rates for SPS Plant assets? A. In general, net salvage values are the amount received for retired property (salvage) less any costs incurred to sell or remove the property (removal). When salvage exceeds removal (positive net salvage), the net salvage reduces the amount to be depreciated over time. When removal exceeds salvage (negative net salvage), the negative net salvage increases the amount to be depreciated. In this Depreciation, the net salvage percentages used is not based on actual experience and dismantling cost estimates but on this s long-standing precedent of negative five percent for each property account, except land and water rights accounts where a zero percent net salvage is used. Q. What are the currently approved net salvage values for Production and Other Production assets? A. The currently approved net salvage rates for Production and Other Production are positive five percent, with zero percent net salvage for land rights accounts. Those rates were set in the stipulation agreement in Docket No Q. What has been the s practice in approving net salvage percentages for Production and Other Production assets? A. The has historically used negative five percent and zero percent net salvage rates for Production and Other Production, respectively. Most recently, Watson Direct Revenue Requirement Page 24 RR2-406 of

25 the approved a negative five percent net salvage for Production plant in Docket No , Entergy s recent rate case. 10 Q. When was the negative five percent first used at the? A. The first used negative five percent in 1978 in Docket No for Texas Electric Services Company ( TESCO ). The basis for the negative five percent was a study conducted by Electric Bond and Share Co. on two lignite-fueled generating units owned by what would eventually become TXU. The final order in Docket No quoted the reason to change to the negative five percent net salvage for production as to more clearly reflect actual retirement experience of its generating units [TESCO s proposal of negative five percent] is a more accurate estimate of net salvage values that will be experienced in the future. Q. What was the basis for the s approval of zero percent net salvage for Other Production Plant? A. In the mid-1980s, net salvage values for Other Production were based on the specific facts and circumstances surrounding the assets in that function. For example, the first assets in Other Production were small internal combustion engines (similar to a large car engine) with very little removal cost and no costs associated with environmental issues. The facts supported a zero percent net 10 Docket No , Order on Rehearing, FoF 101 (Nov. 1, 2012). 11 Application of Texas Electric Service Company for Authority to Change Rates and Inquiry by Public Utility of Texas into Certain Affiliated Transactions of Texas Electric Service Company, Texas Power and Light, and Dallas Power and Light Company, Docket No (Apr. 20, 1979). Watson Direct Revenue Requirement Page 25 RR2-407 of

26 salvage at that time. In later cases such as Docket No , 12 Texas Utilities Electric Company had only a very small number of assets related to leased combustion turbines in the Other Production function. Part of the lease cost was the removal of the combustion turbines at the end of the lease. Again, the facts at that time supported a zero percent net salvage for Other Production. In contrast, in today s environment, suggesting that a zero percent net salvage rate for SPS is appropriate for its combustion turbine plants is not supportable by the facts surrounding the retirement and removal of those assets. Q. Earlier in your testimony, you stated that the TLG Production Dismantling Cost presented in SPS s 2012 rate case (Docket No ) supports SPS s proposal to use negative five percent net salvage values for Production and Other Production plant. How does the TLG Production Dismantling Cost support SPS s proposal? A. The TLG Production Dismantling Cost represents a more realistic projection of Production and Other Production terminal net salvage values for SPS than do the values reflected in SPS s current net salvage rates. The TLG Production Dismantling Cost is a more accurate estimate of terminal net salvage values that SPS will experience in the future for the following three reasons: 1. Over the years, dismantling costs have continued to increase as evidenced by companies filing increasingly negative net salvage studies. Vague suggestions of productivity increases have been far outweighed by the 12. Application of Texas Utilities Electric Company for Authority to Change Rates, Docket No (Jan. 28, 1994). Watson Direct Revenue Requirement Page 26 RR2-408 of

27 costs associated with complying with increasing environmental regulations and escalating labor costs required to remove generating plants from service. Companies have become more environmentally sophisticated since the late 1970s. The original 1978 study did not even consider the costs of removing asbestos, transit, and other environmental hazards that now have to be considered at a significant cost. 2. The TLG Production Dismantling Cost represents a site-specific analysis of every Production facility owned by SPS. Site-specific data for SPS owned assets are far superior to data extrapolated from an analysis with a small sample size (only two lignite-fueled units) that are owned by another company. 3. Utility assets typically have a long useful life. When those assets are retired, the cost to demolish and dispose will have increased significantly because of inflation. Ever changing environmental regulations and disposal requirements must also be factored into dismantling cost. However, SPS is requesting only to move from the current positive five percent to a negative five percent as a first step in reflecting the costs needed at the time of retirement of these facilities. Q. Is the use of the precedent negative five percent a conservative representation of the dismantling costs SPS will incur at the end of the lives of its generating assets? A. Yes. The actual cost that SPS will eventually incur will be much higher and at future prices. Given that the generating units are expected to be in service a number of years before retirement and dismantling, the negative five percent used in the study is very conservative. If the estimated costs in 2012 dollars from the TLG dismantling study or the future costs for dismantling were used in the study, the resulting depreciation rates would be significantly higher than those recommended in this filing. Watson Direct Revenue Requirement Page 27 RR2-409 of

28 Q. Why would using the TLG Dismantling Result in higher depreciation rates? A. The TLG study would reflect higher removal costs and therefore more negative net salvage. 3. Depreciation Rate for Production and Other Production Assets Q. Please describe the results of the Depreciation for Production Plant. A. The results of the analysis conducted in the Depreciation, based on the service life of production assets and the revised net salvage rates, resulted in an 9 increase to SPS s depreciation rates for production plant. SPS s present depreciation rates were compared to the Depreciation recommendations in Appendix B of Attachment DAW-RR-2. The rates proposed for Production assets would be an increase of approximately $22 million, or a 1.3 percent increase in annual depreciation rates, from SPS s present depreciation rates. Ms. Perkett will discuss the effect of the proposed rates on SPS s test-year depreciation expense. Q. Please describe the major changes that resulted in the increase. A. The major reason for the increase in depreciation rates is the reflection of a negative five percent net salvage compared to the positive five percent net salvage amounts embedded in current rates. P.U.C. SUBST. R (b)(1)(B) requires SPS to ratably recover from customers the future cost to remove all assets currently in service on a straight-line basis over the life of the assets. This means that net salvage rates must be calculated in order to allow recovery in current rates of the expected cost to remove the assets that SPS currently has in service over the expected life of those assets. P.U.C. SUBST. R (b)(1)(B) ensures that Watson Direct Revenue Requirement Page 28 RR2-410 of

29 the cost of the asset, including removal cost, is collected from all customers, both current and future, that benefit from the use of the asset on an equitable basis. The s rules and historic practice of using straight-line depreciation to ensure the equitable recovery of removal costs for assets support SPS s proposed 5 depreciation rates and net salvage amounts. Without proper recognition of removal costs, the concept of straight-line depreciation is also violated as the rates will have to increase at the end of a unit s life or after the plant has retired to ensure full recovery of costs. Q. Please describe the results of the Depreciation for Other Production plant. A. The results of the analysis conducted in the Depreciation, based on the service life and the revised net salvage rates, resulted in an increase to SPS s depreciation rates for Other Production plant. SPS s present depreciation rates were compared to the Depreciation recommendations in Appendix B of Attachment DAW-RR-2. The rates proposed for Other Production assets is an increase of approximately $865,000, or a 0.31 percent increase in annual depreciation rates, from SPS s present depreciation rates. Ms. Perkett will discuss the effect of the proposed rates on SPS s test-year depreciation expense. D. Transmission, Distribution, and General Property 1. Life of Transmission, Distribution, and General Assets Q. What is the significance of an asset s useful life in your Depreciation? A. An asset s useful life is used to determine the remaining life over which the remaining cost (original cost plus or minus net salvage, minus accumulated Watson Direct Revenue Requirement Page 29 RR2-411 of

30 depreciation) can be allocated to normalize the asset s cost and spread it ratably over future periods. Q. How did you determine the average service lives for each account? A. The establishment of appropriate average service lives for each account within a functional group was determined by using either of two widely accepted 6 depreciation analyses: actuarial analysis or Simulated Plant Record ( SPR ) methods. Because the vintaged data used in actuarial analysis contains more information than the un-aged data used in SPR analysis, actuarial analysis is the preferred analysis tool when there are a sufficient number of transaction years 10 available to model an account. Mass distribution accounts did not contain vintaged transaction history, so SPR analysis was used for these accounts. Graphs and tables supporting the actuarial analysis and SPR analysis and the chosen Iowa Curves (which represent the percentage of property remaining in service at various age intervals) used to determine the average service lives for analyzed accounts are found in the SPS Depreciation (Attachment DAW-RR-2) and the workpapers filed in Attachment DAW-RR-3(CD). As detailed in the study, I relied on my judgment to incorporate any differences in the expected future life characteristics of the assets into the selection of lives. The objective of life selection is to estimate the future life characteristics of assets, not simply measure the historical life characteristics. More information can be found in the life analysis section of the SPS Depreciation in Attachment DAW-RR-2. Watson Direct Revenue Requirement Page 30 RR2-412 of

31 Q. Does your Depreciation reflect any changes in the useful lives of the Transmission, Distribution, and General function assets from the lives embedded in the current depreciation rates? A. Yes. As shown in Appendix C of Attachment DAW-RR-2, 17 accounts have increases in life. The greatest change is an increase of 20 years in FERC Account 366. There is one account, Account 393 Stores Equipment, where a decrease in life of 10 years is recommended. The lives for the other 14 accounts remained unchanged. 2. Net Salvage Rates Transmission, Distribution, and General Q. How did you determine the net salvage rates that you used in your study for Transmission, Distribution, and General property? A. I examined the experience realized by SPS by observing the average net salvage rates for various bands (or combinations) of years. Using averages (such as the 5-year average band) allows the smoothing of timing differences between when retirements, removal cost and salvage are booked and smoothes the natural variations between years. By looking at successive average bands, or rolling bands, an analyst can see trends in the data that would signal the future net salvage in the account. This examination, in combination with the feedback of SPS personnel related to any changes in operations or maintenance that would affect the future net salvage of SPS, allowed for the selection of the best estimate of future net salvage for each account. Watson Direct Revenue Requirement Page 31 RR2-413 of

32 Q. Is this a reasonable method for determining net salvage rates? A. Yes. This methodology is commonly employed throughout the industry and is the method recommended in authoritative texts. Q. Does your Depreciation reflect any change in the net salvage values of the Transmission and Distribution property from the existing net salvage rates embedded in SPS s current depreciation rates? A. Yes. The net salvage values for both Transmission and Distribution property continue to experience increasing cost of removal and declining gross salvage. The recommended net salvage values used in the calculation of the Transmission and Distribution depreciation rates, along with the current net salvage values for comparison, are listed in Attachment DAW-RR-2, Appendix C with detailed computation in Appendix E-2. Additionally, Attachment DAW-RR-2 contains a detailed net salvage analysis for Transmission and Distribution property, by account 3. Depreciation Rates for Transmission, Distribution, and General Property Q. Please describe the results of the Depreciation for Transmission plant. A. The results of the analysis conducted in the Depreciation, based on the service life of transmission plant and the revised net salvage rates, resulted in an 20 increase to SPS s depreciation rates for transmission plant. SPS s present depreciation rates as authorized by the were compared to the Depreciation recommendations in Appendix B of Attachment DAW-RR-2. The rates proposed for Transmission assets is an increase of approximately $309,000, or an approximately percent increase in annual depreciation Watson Direct Revenue Requirement Page 32 RR2-414 of

33 rates, from SPS s present depreciation rates. Ms. Perkett will discuss the effect of the proposed rates on SPS s test-year depreciation expense. Q. Please describe the results of the Depreciation for Distribution plant. A. The results of the analysis conducted in the Depreciation, based on the service life of distribution plant (Texas only) and the revised net salvage rates, resulted in a decrease to SPS s depreciation rates for distribution plant. SPS s present depreciation rates as authorized by the were compared to the proposed Depreciation recommendations in Appendix B of Attachment DAW-RR-2. The rates proposed for Distribution assets is an increase of 0.10 percent from SPS s present depreciation rates. Ms. Perkett will discuss the effect of the proposed rates on SPS s test-year depreciation expense. Q. Please describe the results of the Depreciation for FERC Accounts (land rights, and structures and improvements). A. The results of the analysis conducted in the Depreciation, based on the service life of FERC Accounts and the revised net salvage rates, resulted in an increase to SPS s depreciation rates for FERC Accounts SPS s present depreciation rates as authorized by the were compared to the proposed Depreciation recommendations in Appendix B of Attachment DAW-RR-2. The rates proposed for FERC Accounts would be an increase of $861,000, or an approximate 1.4 percent increase in annual depreciation rates, from SPS s present depreciation rates. Ms. Perkett will discuss the effect of the proposed depreciation rates on SPS s test-year depreciation expense. Watson Direct Revenue Requirement Page 33 RR2-415 of

34 Q. Please describe the major changes that resulted in the changes in depreciation rates for electric Transmission and Distribution property. A. Changes in service life, gross salvage, gross removal costs, curve selection, and adjustments due to a theoretical reserve comparison are all factors that affect the calculation of the depreciation accrual. The proposed changes in the Depreciation analysis for Transmission and Distribution assets suggest adjustments that 7 both increase and decrease the total accrual. However, one of the factors influenced the accrual calculation notably and consistently in one direction: most of the increase in depreciation expense for Transmission and Distribution assets can be attributed to the effect of changes to net salvage rates. In Docket No , the stipulation did not move net salvage rates to accurate levels. For nearly every Transmission and Distribution asset group, the residual value of assets has been decreasing while at the same time labor and disposal costs having been increasing. The effect on the calculation of net salvage is then two fold. There is a downward trend on gross salvage and an upward trend on the cost of removal that has been occurring for many years. When net salvage becomes increasingly negative, depreciation expense increases over previous levels. To remedy the shortfall caused by the current depreciation rates, the should approve the net salvage parameters proposed in the Depreciation to provide SPS straight-line asset recovery and prevent intergenerational inequities. Watson Direct Revenue Requirement Page 34 RR2-416 of