1. 31st National Conference of Unit Valuation States
San Antonio, Texas
October 27 – 29, 2015
Unitary Valuation: Economic
Obsolescence Adjustment
Conundrum in the Cost Approach
Bwembya Chikolwa
Staff Appraiser
Property Tax Assistance Division
Texas Comptroller of Public Accounts

2. Disclaimers
The statements made or opinions expressed by the
author/presenter in this presentation or related materials do
not necessarily represent a policy position of the Texas
Comptroller of Public Accounts’ Property Tax Assistance
Division.
Materials presented on the subject topic are neither definitive
nor exhaustive and only present matters the author/presenter
believes to salient.
As such, the presented material should not be quoted without
prior consent of the author/presenter.

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Topics
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 Cost approach model
 Economic obsolescence defined
 Tests for economic obsolescence
 Economic obsolescence models
 Regulatory framework for the utility, pipeline, railroad,
telecommunication industries
 Investment returns by asset class
 Take aways
 Case study appraisals
 Roundtable discussion

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Cost approach model
Property Cost and Obsolescence Components
Source: Reilly , R. 2012. Functional Obsolescence and Economic Obsolescence Considerations in the Property Tax Valuation. Insights
magazine, Summer 2012. Chicago: Willamette Management Associates
4

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Economic obsolescence defined
 Economic obsolescence, also referred to as external obsolescence, is the loss in value
resulting from influences external to the property itself
 International, national, industry-based, or local in origin
 Incurable
 Subject property’s inability to generate a market-based rate of return on investment (ROI)
Source: American Society of Appraisers (2011), Valuing Machinery and Equipment: The Fundaments of Appraising Machinery and
Technical Assets, 3rd Ed., Washington, D.C., . pp. 76
 Economic obsolescence is loss in value caused by negative externalities, i.e., factors
outside a property
 Temporary or permanent
 Almost always incurable
 Marketwide effect and influences a whole class of properties
Source: Appraisal Institute (2013), The Appraisal of Real Estate, 14th Ed., Chicago. pp. 632
 Economic obsolescence has been interpreted as ‘changes in demand and requirements
of public authorities’ in some court cases
 e.g., PacificCorp v. State of Montana, 253 P.3d at 854
Source: Code of Federal Regulations, 2007
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Test for economic obsolescence
 Conditions that may indicate existence of economic obsolescence
 Income approach value < Cost approach value
 Market approach value < Cost approach value
 Decrease in the following factors in recent years for the subject and the industry:
 Revenue
 Profitability
 Cash flow
 Product pricing
 Profit margins
 Returns on investment
 Increase of competition in recent years for the subject and the industry
Source: Reilly , R. 2012. Functional Obsolescence and Economic Obsolescence Considerations in the Property Tax Valuation.
Insights magazine, Summer 2012. Chicago: Willamette Management Associates
 Conditions that may indicate existence of economic obsolescence
 Reduced demand for the company’s products
 Overcapacity in the industry
 Dislocation of raw material supplies
 Increasing cost of raw materials, labor, utilities, or transportation, while the selling price of the product
remains fixed or increases at a much lower rate
 Government regulations that require capital expenditures to be made with little or no return on the new
investment
 Environmental considerations that require capital expenditures to be made with little or no return on the
new investment
Source: Remsha, M.J. 2010. Identifying and Quantifying Economic Obsolescence. American Appraisal
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Economic obsolescence models
 Utilization Analysis
 Equity-to-Book Ratio Analysis
 Best of the Best (Blue-Chip) Technique
 Income Shortfall Analysis
 Government Regulations Analysis
 Market-Derived Approach
 Income Approach
 Return-on-Capital Analysis
 Gross Margin Analysis
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 EO can be quantified using many different methods:
 Model selection depends on data availability and type of asset being valued
Note:
The last two methods are not extensively used in unitary valuation. Some of methods discussed in this presentation are derivations of
market and income methods

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Utilization method
 Calculating economic obsolescence using the ‘Utilization method’.
 “Whenever the operating level of an asset is significantly less than its rated or design
capability… the asset is less valuable than it would otherwise be”
Source: American Society of Appraisers (2011), Valuing Machinery and Equipment: The Fundaments of
Appraising Machinery and Technical Assets, 3rd Ed., Washington, D.C.
 Inutility Formula:
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 X = scale factor → “6/10ths Formula” used
 Capacity A: Design/Supply; Capacity B: Current/Demand
 Used in:
- Telecommunications industry
- Pipeline industry:
BP Pipelines (Alaska) Inc. v. State of Alaska, Department of Revenue, ---P.3d---, 2014 WL
685986 (Alaska Feb. 19, 2014)
 Audited financial data v. Internal unaudited data

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Equity-to-book ratio method
 Calculating economic obsolescence using the ‘Equity-to-book ratio method’.
 Derived from sales approach: market-to-book ratio in excess of one implies a sale price in
excess of book value; vice versa is also true
Source: American Society of Appraisers (2011), Valuing Machinery and Equipment: The Fundaments of
Appraising Machinery and Technical Assets, 3rd Ed., Washington, D.C.
9
 Used to check if economic obsolescence exists:
- PacifiCorp v. State of Montana, Dept. of Revenue, 253 P.3d 847 (Mont. 2011)
 Stock & Debt method arguments:
- Discounts and premiums
- Investor intent
BK Value MK Value MK to BK Book Market MK to BK
Per Share Per Share Ratio Value Value Ratio
Company Name Ticker A B C = B/A D E F = E/D
Sunoco Logistics Partners L.P. SXL 58.51 48.93 0.8362 1,589,000,000 1,732,000,000 1.0900
Enbridge Energy Partners LP EEP 14.69 29.02 1.9754 5,701,700,000 6,604,500,000 1.1583
Magellan Midstream Partners LP MMP 6.70 50.59 7.5495 2,323,408,000 2,721,985,000 1.1715
Nustar Energy LP NS 33.03 45.59 1.3804 2,411,004,000 2,377,120,000 0.9859
Buckeye Partners, L.P. BPL 24.12 47.77 1.9803 2,941,444,000 3,074,862,000 1.0454
Enterprise Products EPD 14.60 51.75 3.5449 14,655,200,000 14,655,200,000 1.0000
Kinder Morgan Egy Ptnrs L.P. KMP 30.34 81.26 2.6779 17,330,000,000 18,911,000,000 1.0912
Plains All American PL LP PAA 19.80 52.62 2.6581 6,320,000,000 7,300,000,000 1.1551
Average Book to Market: 2.8253 Average Book to Market: 1.0872
Equity 74.00% x 2.83 = 2.09
Debt 26.00% x 1.09 = 0.28
100.00% 2.37
M/B Ratio = 2.38
Notes:
A: Book value per share = (total equity - preferred equity - noncontrolling interest) / Outstanding shares
B: Market value per share = share price from Yahoo Finance/NYSE, etc.
D&E: Company financials show outstanding long term debt and its fair value.
Industry Market Capital Structure
PIPELINE INDUSTRY
Book to Market - Common Equity Per Share Book to Market - Long-Term Debt

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Blue-chip technique
 Calculating economic obsolescence using the ‘Best of the best method’.
 EO involves selecting several economic performance indicators for comparable
companies, such as rate of return, gross or net margins, and utilization, among others, for
comparison against the subject
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 Used in electric coop industry
 Was used in railroad industry
 RCLD v. HCLD
 Relevance v. Hodgepodge
STANDARD #1 STANDARD #2 STANDARD #3 STANDARD #4 STANDARD #5
MWH / MWH / NET MWH / O & M EXP. MWH / DIST. CUSTOMERS /
COMPANY CUSTOMER DIST. PLANT Less POWER EXP. O & M EXP. NET DIST.
Center Point H (T&D) 35.6882 0.0235 0.0663 0.3504 0.0007
Oncor Electric D (T&D) 34.7092 0.0194 0.0791 0.5729 0.0006
TNMP (T&D) 34.4549 0.0157 0.0639 0.3877 0.0005
Entergy Texas, Inc. (FI) 53.2518 0.0201 0.1301 0.6728 0.0004
Southwestern Electric Co. (FI) 54.3288 0.0236 0.1078 0.3908 0.0004
Southwestern Public Serv. (FI) 73.4368 0.0392 0.0938 0.7817 0.0005
Mean - All 47.6450 0.0236 0.0902 0.5261 0.0005
Mean - FI Only 60.3391 0.0276 0.1106 0.6151 0.0004
Subject Property % Good Calculation IOU Standards
% GOOD 1 (MWH/CUST/ 60.33914 ) = 0.334104
% GOOD 2 (MWH/NDTP/ 0.02764 ) = 0.198514
% GOOD 3 (MWH/OPEX/ 0.11056 ) = 0.444839
% GOOD 4 (MWH/DTEX/ 0.61511 ) = 0.177044
% GOOD 5 (CUST/NDTP/ 0.00045 ) = 0.606548
AVG % GOOD 0.352210
Net Book Value = 1,171,800,535
LESS: Economic Obsolescence (1 - 0.35221) 759,081,101
412,719,434Indicated Value

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Income shortfall method (1)
 Calculating economic obsolescence using the ‘Income shortfall method’.
 Percentage return differential between the projected allowed (regulated) rate of return and
a hypothetical market (unregulated) rate of return, which is then discounted to present
value.
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Based on
Projected Return-
to-Net Book
Based on Previous
Year's Return-to-
Net Book
YE 2014 YE 2013
Net Book Value 908,505,802 848,159,633
Cap Rate (x) 8.90% 8.90%
Expected Income 80,857,016 75,486,207
Projected Income (a) / Prior Year's Income (b)
(-) 47,234,634 (a) 40,192,652 (b)
Income Shortfall 33,622,382 35,293,555
Cap Rate (÷) 8.90% 8.90%
377,779,574 396,556,802
Net Book 908,505,802 908,505,802
Less Economic Obsolescence (c & d):
1 - ( 377,779,574 ÷ 908,505,802) (-) 377,779,574 ('c) 424,771,636 (d)
1 - ( 396,556,802 ÷ 848,159,633)
Market Value 530,726,228 483,734,166
Adopted Market Value 507,230,197
Value
always
equals that
from
Income
Approach

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Income shortfall method (2)
 Legal precedents against/for the ‘Income shortfall method’.
 Recent court rulings on method though inclined ‘against’, show that issue is not settled with certainty.
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AGAINST
1971 Northern Natural Gas v. Deweyer, 208 Kansas 337, 492 P.2d 147
1976 In re: Onondaga County Water District v. Board of Assessors of Minetto, 39 N.Y.2d 601, 350 N.E.2d
390
1979 Consumer's Power Co. v. Port Seldon Township, 91 Mich. App. 180, 183 N.W.2d 680
1979 Utah Power & Light Co. v. Utah State Tax Comm’n., 590 P.2d 332 (Ut. 1979)
1988 AT&T Communications v. Department of Revenue, Wash, BTA Bo. 33619
1988 Transcon. Gas Pipe Line Corp. v. Bernards Twp., 545 A2.d 746, 754 (N.J. 1988)
1989 United Telephone Co. v. Dep't of Revenue, 770 P2d. 43
1989 Pacific Power & Light Co. v. Dept. of Revenue, State of Oregon, 775 P.2d 303 (Or. 1989)
1990 Michigan Bell Telephone Co. v. Dep't of Treasury, Michigan Tax Tribunal, Docket No. 90553
1994 aff'd Michigan Bell Tel. Co. v. Department of Treasury, 445 Mich. 470, 518 N.W.2d 808
1997 Alta Pac. Assoc., Ltd. v. Utah State Tax Comm'n., 931 P.2d 103, 112 (Ut. 1997)
1999 Delta Air Lines, Inc. v. Dept. of Revenue, State of Oregon, 984 P.2d 836, 849 (Or. 1999).
2008 Eurofresh, Inc. v. Graham County, 187 P.3d 530, 537 (Ariz. App. 2008)
2009 Quest v. State of Montana, Department of Revenue, SPT 2008-2 (Nov 30, 2009, on appeal).
2011 PacifiCorp v. State of Montana, Dept. of Revenue, 253 P.3d 847 (Mont. 2011).
2011 Jones v. Southern Natural Gas Co., 63 So.3d 1080 (La. Ct. App. 2011)
2012 Southwest Airlines Co. v. Arizona Dept. of Revenue, 2012 WL 3041179 (Ariz. App. 2012)
FOR
1980 Burlington Northern, Inc. v. Dept of Revenue, 291 Ore. 729
1998 Canal Square Limited Partnership v. State Board of Tax Commissioners, 694 N.E.2d 801(Indiana
1998)
1994 GTE North Incorporated v. Indiana Board of Tax Commissioners, 634 N.E.2d 882
2011 United Airlines, Inc. v. Prop. Tax Adm'r (Colo. Bd. of Assessment, App., N. 53259, Oct. 19, 2011)
2012 PacifiCorp v. Idaho State Tax Commission, 291 P.3d 442 (Supreme Court of Idaho 2012)
2012 Boston Gas Co. v. Board of Assessors of Boston, 82 Mass.App.Ct. 517, 976 N.E.2d 176
(Mass.App.Ct., 2012), 10/3/12.
2012 Beaver County v. Property Tax Division of the Utah State Tax Comm'n, No. 080905451 (3rd Dist. Ct.
Utah, Feb. 15, 2012)
2014 BP Pipelines (Alaska) Inc. v. State of Alaska, Department of Revenue, ---P.3d---, 2014 WL 685986
(Alaska Feb. 19, 2014)
2015 State of Alaska, Department of Revenue v. BP Pipelines (Alaska) Inc, ---P.3d---, 2015 WL 5061652
(Alaska August 28, 2015)
-Tariff regulation is not a form of economic obsolescence
-Excess capacity is a form of economic obsolescence

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Govt. regulations method (1)
 Calculating economic obsolescence using the ‘Govt. regulations method’.
 Loss in earnings resulting from the ‘regulatory lag’, i.e., the allowed rate of return was not
permitted to be increased fast enough, and the utility was not being given the opportunity
to earn on its rate base at current market rates
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Govt. regulations method (2)
 Formula:
EO =
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 − 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝑨𝑨𝑨𝑨𝑨𝑨 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹
 Salient facts on govt. regulation:
 Social/regulatory compact v. Regulatory capture
 ‘Just and reasonable’ principle → ‘Zone of reasonableness’
 Earned ROEs ≥ Allowed ROEs
 Govt. regulators do not determine market value, market participants do
 Govt. regulations influence property values
 Ability to recover and earn returns and a conducive regulatory framework heavily impact
credit ratings, e.g. Moody’s Investor Service weights 50% for the two in utility industry
ratings
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Govt. regulations method (3)
 AEP Texas North Company
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Year-End 2010 2011 2012 2013 2014
Allowed Rate of Return† 7.72% 8.01% 7.89% 7.21% 7.23% PUCT Allowed Return (WACC)
Current Desired Rate of Return 9.75% 9.24% 8.23% 8.97% 8.90% Capitalization Rate
Indicated Fraction Non-Obsolete 79.16% 86.63% 95.87% 80.36% 81.24%
Regulatory Analysis Economic
Obsolescence
20.84% 13.37% 4.13% 19.64% 18.76% = 1 - ((Market Return - Allowed
Return)/Market Return)
Notes:
1. Capitalization rate is a proxy for market return or desired rate of return.
2. †PUCTEarnings Report, Sch. V. Allowed ROE 9.96% on 12/13/2007, Docket No. 33309.

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Govt. regulations method (4)
 Some utilities are able to tie their ROE with regulatory lag
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Govt. Regulation: For v. Against
 For:
 “To be truly successful, free markets
require common-sense regulation to
prevent manipulation and deceit”
Robert Shiller, 2013 Nobel Laurette
in Economics. “Faith in an Unregulated
Free Market? Don’t Fall for It,” NY Times,
Upshot, Oct. 9., 2015
 “Markets Can Be Very, Very Wrong”
Paul Krugman, 2008 Nobel Laurette
in Economics. The Conscience of a
Liberal, NY Times, Sept. 30, 2011
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 Against:
 “Actual market prices are, on the
basis of all available information,
best estimates of intrinsic values”
Eugene F. Fama, 2013 Nobel Laurette
in Economics, father of the efficient
markets hypothesis
 “Governments never learn. Only
people learn”
Milton Friedman, 1976 Nobel Laurette
in Economics, grandmaster of
free-market economic theory

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Govt. Regulation: Electric/Gas Distribution Industries
 Regulatory agencies:
 Federal Energy Regulatory Commission - Federal
 Railroad Commission of Texas – State → Gas Distribution
 Public Utility Commission (PUC) – State
 Environmental Protection Agency (EPA) - Federal
 North American Electric Reliability Corporation (NERC)
 Mandates:
 Cost-of-service/cost-based rates
 Safety
 Reliability
 Environmental protection
 M&A approval
 Recent events:
 FERC Order 1000 → To increase competition in electric transmission industry
 EPA’s Clean Power Plan → Reduction of carbon pollution from the power section
 Cyber & Grid Security → Issues, impacts, and costs associated with the risks of cyber-physical attacks on
power infrastructure
 Coal to gas switching
 Renewables → ~17% of operating generating capacity, 65% of new capacity
 Smart grid/Smart meter technology/Grid neutrality/Microgrids
 Economics of storage → Tesla and SolarCity story, et. al
 Rate recovery mechanisms:
 Riders
 Trackers
 Factors
 Clauses
 Forward test years
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 Test questions on economic obsolescence:
 What, where & how
 Negative impact

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Govt. Regulation: Pipeline Industry
 Regulatory agencies:
 Federal Energy Regulatory Commission (FERC) - Federal
 Railroad Commission of Texas (RRC) – State, Texas only
 U.S. Dept. of Transport, PHMSA – Federal
 U.S. Dept. of Transport, STB – Federal, Ammonia
 EPA – Federal: Clean Water Act, Oil Pollution Act, Clean Air Act, et. al
 Mandates:
 Cost-of-service/cost-based rates
 Safety
 M&A approval
 Environmental protection
 Recent events:
 Shale play pipeline build out
 Pipeline ruptures
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 Test questions on economic obsolescence:
 What, where & how
 Negative impact

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Govt. Regulation: Railroad Industry
 Regulatory agencies:
 Surface Transportation Board (STB) - Federal
 Federal Railroad Administration (FRA) – Federal
 U.S. Dept. of Transport, PHMSA – Federal
 Mandates:
 Authorized rates/Revenue adequacy
 M&A approval
 Rail abandonment
 Safety
 Recent events:
 Positive train control → Dec. 31, 2015 deadline
 Crude-by-rail (CBR) → ~5-6% of revenue
→ New rules: Robust tank cars; lower speed limits; electronically
controlled brakes
 Coal volumes → ~15-20% of revenue
 Alabama DoR v. CSX → 4R-Act:Comparison with competitors to determine if tax is
discriminatory
 Rate protection for certain “captive shippers”
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 Test questions on economic obsolescence:
 What, where & how
 Negative impact

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Govt. Regulation: Telecommunications Industry
 Regulatory agencies:
 Federal Communications Commission (FCC) - Federal
 Public Utility Commission (PUC) – State
 Mandates:
 Authorized rates
 Universal service fund
 M&A approval
 Recent events:
 AT&T’s ‘Project Velocity IP’ → FCC application to shut-down or divest its copper network
 Title II of Communications Act → Reclassification of broadband as a utility
→ Net Neutrality
 FCC’s ‘Connect America Funding Phase II’ → 2015 support for broadband deployment
 Wireless spectrum auctions & wars
 Convergence in the Telecom Industry
 Test questions on economic obsolescence:
 What, where & how
 Negative impact
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Investment Returns: Electrics
 Where are utilities relative to the S&P 500?
 ‘Just and reasonable’ principle
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Investors with a low risk appetite in search of income favor the utility sector, as utility stocks
have low beta and offer attractive yields

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Investment Returns: MLPs
 10-year performance value of $1,000 invested
23
Source: AMZ/Alerian MLP Index fact sheet as of June 30, 2015

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Take Aways (1)
 At trial, ‘Go Big or Go Home’
 …..The district court noted that it “was especially impressed by
Mr. Tegarden and found his testimony and opinions to be
more credible, more reliable, more persuasive, and entitled to
greater weight than the testimony and opinions of the
witnesses for the Tax Commission”
Source: PacifiCorp v. Idaho State Tax Commission, 291 P.3d 442 (Supreme
Court of Idaho 2012)
 Bearer of the burden of proof: Taxpayer v. Assessor
 Additional reductions of adjustments might be made if a
taxpayer could show that additional depreciable value existed
Source: PacifiCorp v. State of Montana, Dept. of Revenue, 253 P.3d 847
(Mont. 2011)
 Submission of competent evidence
 Establishment of factors comprising the claimed obsolescence
 Identification of affected assets
 Quantification of the amount of obsolescence for each asset
 Tariff income is not a primary driver of economic value. Excess
capacity is a form of economic obsolescence
Source: BP Pipelines (Alaska) Inc. v. State of Alaska, Department of Revenue, -
--P.3d---, 2014 WL 685986 (Alaska Feb. 19, 2014)
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Take Aways (2)
 Economic obsolescence, by definition, does not occur to a strong and growing
company, but rather in one that is a victim of external forces which hamper its income
earning capacity
Source: PacifiCorp v. State of Montana, Dept. of Revenue, 253 P.3d 847 (Mont. 2011)
 FERC definition of depreciation
 Depreciation studies occur every 4 – 5 years
 May not incorporate all forms of obsolescence
 Decision to deduct for external obsolescence is a product of appraisal judgement
Source: PacifiCorp v. Idaho State Tax Commission, 291 P.3d 442 (Supreme Court of Idaho 2012)
 The ‘Income shortfall method’, if not tied to the income approach result, is a valid
methodology provided it is correctly applied
Source: ©2015 Bwembya Chikolwa
25

26. © 2015 Bwembya Chikolwa No portion of this presentation may be reproduced, reused, or otherwise distributed in any form without prior written consent.
For more information please contact
Bwembya Chikolwa
Staff Appraiser
Property Tax Assistance Division
Texas Comptroller of Public Accounts
(512) 475 5677
bwembya.chikolwa@cpa.texas.gov
26

27. Additional Disclaimers
 Apologies for putting too many details on slides
 No political persuasion is being advanced
 This discussion/presentation is irrelevant as everything
has been/will be decided by the courts of law. However:
 It’s prudent to question our redundancy
 To explore ways of changing our minnow status
 Presentation is based on assumption after assumption:
 Holmesian Mysteries
 Acting as a polemicist in this presentation

28. © 2015 Bwembya Chikolwa Not to be reproduced, reused, or otherwise distributed in any form without prior written consent
RAILROADS
PIPELINES
ELECTRICS/GAS
DISTRIBUTION
TELECOM/
TECHNOLOGY
POSITIVE
TRAIN
CONTROL
GIS
MAPPING/
SAFETY
REMOTE
SENSING &
IMAGING
SMART
TECH/
CYBER
SECURITY
CBR ~5-6% of
railroad revenue
~15-20% of railroad
revenue
~50-60% carbon dioxide
cut for each MWH
Cheaper fuel generation
cost
4.5 times saferEPA mercury
and air toxics
standards
COMPLEX PROPERTY APPRAISAL
EPA/state
methane
emission rules