Which asset valuation and depreciation method should be used for regulated utilities? An analytical and simulation-based comparison

Capital charges constitute the major share of costs in regulated network industries; in regulatory practice, however, no universally accepted method of depreciation exists. This paper compares the most commonly used asset valuation and depreciation methods according to their provision of adequate investment incentives, their compatibility with market developments, and their consistency with financial accounting principles. Current replacement-cost and annuity depreciation are found to be the most advantageous methods. The structural differences between these two methods are presented in detail. A simulation analysis indicates that the differences among the depreciation methods are less pronounced for sets of multiple assets but remain very large for certain parameter constellations, particularly those with substantial asset price changes and long asset lives.