SHORT LEARNING PROGRAMME

Financial Analysis for Economic Regulation

Asset Valuation and Regulatory Tariff

Setting

Dr Stephen Labson

slabson@sleconomics.com

10 September 2015

www.competition.org.za

Session outline

• Regulatory Asset Value is a key determinant of revenue and prices in the predominant forms of

tariff regulation. .

• In South Africa this covers sectors ranging from ports, petroleum pipelines, airports, and Eskom's

generation, transmission and distribution of electricity. (to name a few)

• In this session we examine approaches to regulatory asset valuation applied in determination of

regulated revenue and tariffs. The broad outline of material to be covered includes

• A brief review the role of asset value in regulation of revenue and tariffs as contrasted to

statutory reporting of financial accounts.

• Overview of the predominant approaches to asset valuation observed in regulatory practice.

• An example of how asset valuation methods are sometimes applied in support of regulatory

and industry reform initiatives.

• NB With a brief discussion of administrative issues if time permits.

©slEconomics Pty Ltd 2015

Accounting standards & revenue regulation

Revenue regulation

• Standards and guidelines

• Jurisdictional and sector based.

• Role of asset valuation

• Revenue determination - Measure

of invested capital to be recovered

from tariffs through. return of and

return on capital). .

• Measurement

• Historic cost

• Indexed historic cost

• Trended Original Cost

• Replacement cost / Modern

Equivalent Asset Value

• Line in the sand

• And others to be discussed

Accounting standards

• Standards and guidelines

• International and jurisdictional based conventions.

E.g. IAS 16: Property Plant & Equipment

• Role of asset valuation

• Information- To provide a consistent means of

reporting on an entity's investment in PPE and

changes in asset value

• Measurement

• PPE initially recognized at cost. (After initial recognition

choice of methods).

• Cost - less accumulated depreciation &impairment; or

• Revaluation - fair value less accumulated

depreciation and impairment.

(NB a survey of some 1500 UK and German firms showed

3% choose to use replacement cost for PPE).

• Nikolaev and Christensen, Does Fair Value Accounting fr Non-Financial Assets Pass the Market Test?, April 2013.

The fields of accounting and finance provide a deep history of thought and experience in valuation of assets

– albeit having a very different purpose than applied in the determination of regulated revenue and prices.

Regulatory asset value, revenue allowances and pricing

Regulatory asset value drives twoimportant components of therevenue requirement:

1. The return on capital -calculated as the product ofthe RAB and the WeightedAverage Cost of Capital(WACC).

2. The return of capital – Equalto allowed depreciation of theregulatory asset base.

Building blocks of cost of service regulation

Operations Qualifying expenditures

+

Return on capital Post tax WACC x RAB

+

Return of capital Depreciation of RAB

+

Tax

Tax adjusted for shield on interest

in post tax WACC, or embedded in

use of pre tax WACC

=

Revenue requirementDetermines allowed revenue,

tariffs and charges

The ‘building blocks’ model below illustrates the basis of cost of service regulation and how

asset value enters into the regulatory equation for setting allowed revenue and tariffs*.

* See the following regulatory methodologies

• ;NERSA, “Tariff Methodology for the Setting of Tariffs in the Petroleum Pipelines Industry, 5th Edition”

• Ports Regulator, “Regulatory Manual for Tariff Year 2015/16 – 2017/18”.

• Regulating Committee “Draft Permission to Levey Airport Charges” (2015);,

• NERSA “Multi-Year Price Determination Methodology 1st Edition”...

Cost of service regulation, revenue and price dynamics

• When (fully) recovering invested capital on the basis of return on assets and depreciation (i.e.

building blocks) revenue and averaged prices have a time profile different from what we expect

from market based outcomes:

Operating expenditures and tax

Return of and on capital

Time

A few questions:

1. Should we care? And if so, what can we do about it?

2. Should we expect regulated prices to ‘mimic’ competitive markets? Can

regulated prices mimic competitive markets?

3. Would consumers prefer a smoothed, albeit higher price level? What if NPV

neutral?

4. Can investment occur under these dynamics?

NB. Asset

value and

return drives

this dynamic in

cost of service

regulation.

Approaches to regulatory asset valuation

• A number of approaches to asset valuation are used by regulators ranging from those based on

the company’s statutory reports – through to sector or entity specific arrangements determined by

government policy or legislative instruments.

• Approaches more commonly observed in regulatory practice include the following:

• Depreciated Indexed Cost

• Trended Original Cost

Depreciated Historic Cost

• Modern Equivalent Asset Value

• Depreciated Optimised Replacement Cost

Depreciated Replacement Cost

• Acquisition cost

• Economic value

Line in the sand

Historic cost and application issues

The HC approach references the original construction cost of the asset ideally working from asset

register level data.

• When applied within a cost of service approach HC valuation:

• Just recovers the return of and on invested capital expected for investments of similar risk

characteristics; and

• Provides (real) financial capital maintenance to the investor or entity assuming re-investment of

returns.

• The HC approach has the potential to provide an objective basis for calculation of asset value.

• However, for long lived assets it may be difficult to source original costs. NERSA summed up their

experience in representative assessments in consultation on petroleum storage facilities as follows:*

Trended Original Cost

• A close variant of HC is the “Trended Original Cost”.

• Return on capital = Real WACC * Indexed RAB

• Return of Capital = Depreciation on indexed RAB

• In a simplified model of no tax, TOC and HC (using a nominal rate of return) provide equivalent

outcomes with respect to the net present value of return of and on investment; but it does change the

time profile of returns.*

8* Applied in Transnet Petroleum Pipelines System Tariffs, and Transnet Gas pipelines tariffs among others.

**The long term equivalence of approaches does not hold exactly when tax is considered,

0

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

10 year assumed asset life

Ret

urn

of a

nd o

n c

apita

lR

and o

f th

e d

ay p

rices

(R '0

00)

Real revenue approach

Nominal revenue approach

Real revenue approach 18,400,000 18,304,000 18,170,880 17,997,824 17,781,850 17,519,802 17,208,339 16,843,927 16,422,829 15,941,092

Nominal revenue approach 22,000,000 20,800,000 19,600,000 18,400,000 17,200,000 16,000,000 14,800,000 13,600,000 12,400,000 11,200,000

Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10

1) HC attached to a

nominal rate of

return.

2) TOC attached to

a real rate of return

NB Both provide a

for financial capital

maintenance w.r.t.

inflation if

appropriate return

values are applied.

Profile of Returns – TOC and HC approaches

1. TOC provides for depreciation on an indexed asset base – but obtains a relatively

reduced return on capital (i.e. real WACC x indexed RAB)

CASHFLOWS

Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10

Real approach - Return Of and On Capital

Return on Capital (WACC) 8,000,000 7,488,000 6,922,240 6,299,238 5,615,321 4,866,612 4,049,021 3,158,236 2,189,710 1,138,649

Depreciation 10,400,000 10,816,000 11,248,640 11,698,586 12,166,529 12,653,190 13,159,318 13,685,691 14,233,118 14,802,443

Total Cashflows in Rand of the day 18,400,000 18,304,000 18,170,880 17,997,824 17,781,850 17,519,802 17,208,339 16,843,927 16,422,829 15,941,092

Nominal approach - Return Of and On Capital

Return on Capital (WACC) 12,000,000 10,800,000 9,600,000 8,400,000 7,200,000 6,000,000 4,800,000 3,600,000 2,400,000 1,200,000

Depreciation 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000

Total Cashflows in Rand of the day 22,000,000 20,800,000 19,600,000 18,400,000 17,200,000 16,000,000 14,800,000 13,600,000 12,400,000 11,200,000

2. And as expected – TOC provides a higher depreciated asset value than for the HC

approach – although with depreciation much less than replacement cost for aged assets.

Closing "Real" RAV 93,600,000 86,528,000 78,740,480 70,191,514 60,832,645 50,612,761 39,477,953 27,371,381 14,233,118 0

Closing "Nominal" RAV 90,000,000 80,000,000 70,000,000 60,000,000 50,000,000 40,000,000 30,000,000 20,000,000 10,000,000 0

Replacement cost methods in practice

Indexed Historic Cost

• Asset base escalated by a cost indexreflecting cost of the asset in current Rand

• In this context it can be seen as a proxy forreplacement cost.

• A challenge in applying IHC is in identifyinga suitably robust index that tracks changesin replacement costs, inclusive real andnominal variation in costs in domesticcurrency terms.

• Approaches observed in practice rangefrom:

• Industry or commodity specific indices,to

• General indices such as PPI, CPIX, or

CPI.

Modern Equivalent Asset Value

• Modern Equivalent Asset (MEA) is defined

as an asset having a similar service

potential as the subject asset, judged by its

comparative performance and output, not its

physical characteristics

• The MEAV approach typically builds from

the bottom up in what might be loosely be

characterised as an ‘engineering based’

assessment.

• In calculating MEAV values, one would

ideally work from the asset register and

map to market prices. .

• In practice (for long lived assets) rather

broad aggregates of the asset register

are used due to limitations on

cost/price data.

Two of the more often used proxies for replacement cost are Indexed Historic Cost and Modern

Equivalent Asset Value.(MEAV).

Replacement cost

Replacement cost approaches have gained some level

of acceptance in South Africa - with Eskom’s MYPD

providing an example.

• In determination of Eskom’s regulated revenue allowance

a proxy associated with Modern Equivalent Asset Value* is

used in forming a starting value of the asset base, which is

to be revalued at the next regulatory control period.

• The approach provided in calculation of Eskom’s

revenue allowance is unique in that (as we

understand it) it is a hybrid of RC and TOC whereby a

real WACC is applied to the revalued (starting) asset

base:** i.e.

• Return on Capital = Real WACC x Revalued

(starting) RAB

• Return of Capital = Depreciation on starting RAB

(not indexed).

• NB. Provides a regulatory asset value aligned to

replacement costs at each revaluation of the asset base –

but does not provide for financial capital maintenance or

the NPV equivalency .

NERSA “Multi-Year Price Determination Methodology 1st Edition” and NERSA, “Eskom Holdings Limited: Revenue Application – Multi

Year Price Determination 203/14 to 20117/18 (MYPD3)” Reasons for Decision.

SA Electricity Pricing Policy:

“The revenue requirement for a

regulated licensee must be set at a

level which covers the full cost of

production, including a reasonable

risk adjusted margin or return on

appropriate asset values.

The regulator, after consultation

with stakeholders, must adopt an

asset valuation methodology that

accurately reflects the replacement

value (emphasis added) of those

assets such as to allow the

electricity utility to obtain reasonably

priced funding for investment; to

meet Government defined

economic growth”.

Replacement cost and tariff setting

• RC methods have been applied in various sectors countries such as Ireland, New Zealand and

Australia.

• In assessing RC methods applied to electricity network pricing, Ireland’s regulator had the

following view on price signalling and investment.*

• (the MEAV form of RC) “ensures the RAB is directly linked to the costs of constructing a new

Transmission system” and that “it provides a better indication of changes in market value”

(presumably as compared to original actual cost).

• The statements selected above are (at best) an opaque representation of the role of asset

valuation in regulation of prices.

• For example, while RC and MEAV by definition links to the cost of constructing a new system – the

relevance to regulation and pricing is not at all obvious.

• Unlike statutory reporting, information on its own is not central to the regulatory process - it is

only on application of the revenue formula that the RAB has an effect (e.g. RAB x WACC and

depreciation on the RAB).

• This is not simply a matter of semantics as in moving to the revenue formula it becomes

difficult to maintain “the link” to the cost of a new system.

* CER, Decision on TSO and TAO Transmission Revenue f 22011 to 2015, Nov 2010.

Replacement cost and economic efficiency

• The following statement by the CER

again motivates a broader discussion

of issues one faces in choice of

valuation methodology:.

“Using some form of replacement

value has a very strong economic

foundation.

A precise valuation results in tariffs

that provide an accurate price signal

of the cost of using the transmission

network. ,,,,,

Thus, taking a replacement cost

approach is more likely to result in

the correct level of network

investment.”

The “strong economic foundation” of RC valuation is

perhaps overstated.

• Economists typically view efficient pricing rules in

terms of short run and long run marginal costs.

• Prices set to SRMC will not recover fixed

costs of production – something rather central

to is subject.

• The concept of LRMC is not applicable to

situations of ‘lumpy’ capital additions – again

a characteristic of the industries one would

expect regulation to apply to.

• There is no formalized meaning to the

concept of being ‘relatively close’ to the

optimality conditions of an (efficient) Pareto

optimum.**

• Bertram, “The Optimised Deprival Value Methodology and the Objectives of Utiluty Sector Reform in New Zealand”, 2000.

** Lipsey and Lancaster, The General Theory of Second Best, The Review of Economic Studies Vol. 24, No. 1 (1956 - 1957),

In review of New Zealand’s experience with RC valuation - G. Bertram summed up the matter of

investment well in stating that :

“The crucial incentive requirement is that all new capital expenditure is rolled into the ratebase at

actual prudent cost so that a competitive return can at all times be reasonably expected on a going-

forward basis”.

‘Line in the sand’ valuation methods

As explained by the Australian regulator IPART :

“Under the RAB approach it is common practice for regulators to apply a ‘line-in-the-sand’

to determine the initial value of the RAB, (which essentially locks in the past rate of return

on previous investments). It can then be updated each year, based on capital additions,

disposals and deprecation”

• The line in the sand approach can be placed in the category of deprival value / NPV methods, and

breaks the often cited circularity problem by first establishing price, and then working backwards

to determine the asset value.

• While perhaps rather arbitrary – when applied to State Owned Enterprises the line in the sand

approach can be used to:

• Support the trade sale of assets (e.g. UK privatisation of Electricity supply assets).

• Achieve policy objectives on price outcomes, or long-term financial sustainability.

• Allow for the ‘regulatory write down’ of non-performing assets.

• With practical applications found in:

• Water

• Rail

• Ports (channels)

• Electricity networks

Line in the sand: Industry and regulatory reform

• The approach is often applied in establishing new regulatory regimes in a sector - perhaps in

parallel with market and industry structures such as corporatisation of state owned entities.

• For example, in implementing cost of service regulation across the Australian water sector a ‘line-

in-the-sand’ approach to valuing assets has been used for SOEs to determine revenue

requirements under a cost of service approach:

• The objective of drawing a ‘line in the sand’ may be to maintain prevailing prices (or minimise

price increases) in shifting towards a RAB pricing approach.

• Where a ‘line in the sand’ has been drawn, assets constructed or acquired prior to the date

where the line has been drawn (perhaps a date established for the new regulatory regime )

are deemed to be sunk and written down to a level that reflects their income earning potential

that can be incorporated into an opening RAB..

Put more directly:

• Non-commercial legacy investments can be written down in terms of their impact on regulated

charges.*

• Going forward, capital investments can be subjected to the rigour of investment case planning and

commercial criteria and thresholds.

• Financial performance can be monitored without the overhang of non-commercial legacy

investments.

* The write down we are referring to is for regulatory purposes only, and statutory accounts would typically not be

adjusted in this manner.

Line in the sand for establishment of

regulated charges

• In situations where policy directs the establishment of objective regulatory methods the line in the sand

approach can be used to establish starting asset values for an initial price control period, and then

rolled forward for subsequent control periods:

16

Set line in the sand value e.g. - value on

corporatization; achieves target revenue

/ tariffs, etc.

Roll forward to set starting RAB (e.g. start

of new regulatory controls)

Develop rules for roll forward of starting RAB

during control for determination of allowed revenue.

Develop rules for re-set across regulatory control periods. E.g.. reconciliation of variance of forecast to actual capex,

optimization, etc)

Annual roll forward of the RAB

• Index up for inflation if using TOC

• Transfer in qualifying assets (NB:

define qualifying assets and treatment of

WUC (i.e. recognised in the RAB as

spent or as commissioned.)

• Transfer out disposals

• Depreciate asset base (TOC or HC

basis).

Decide rules for re-set of starting RAB

for next control period,( e.g. RC; TOC;

HC)

NB. May or may not be same approach as for roll forward of initial to starting values

Short list of RAB administration issues

Administrative aspects of asset valuation and roll forward (short list only) .

• Definition of qualifying assets

• Prescribed services

• Government contributions and equity injections (noting terminology and meaning varies

across usage).

• Developer contributions

• Recognition of capital expenditure into the RAB (i.e. as spent, or as commissioned)

• Differential treatment for specific assets?

• Depreciating none, some or all assets prior to commissioning?

• Remaining life of assets and depreciation: e.g.

• Average remaining life for aggregate RAB, or disaggregation of asset categories.

• Straight line or alternative approaches to depreciation. (e.g. accelerated or deferred)

• RAB re-sets across control periods

• Ex ante or ex post optimization of the asset base (i..e . disallowance of assets from the RAB).

• Capex (i.e. reconciliation of variances in forecast to actual expenditures)

• Inflation (i.e. variance in forecast to actual in indexing up the RAB)

• Periodic DRC reviews ? (e.g. updating replacement cost)

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END OF SESSION