Electricity Markets Regulation - Lesson 4 - Regulatory Asset Base
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Experience you can trust. http://www.leonardo-energy.org/training-module-electricity-market-reg ulation-session-4 Training on Regulation A webinar for the European Copper Institute Webinar 4: Revenue Requirements and Regulatory Asset Base (RAB) Dr. Konstantin Petrov / Dr. Daniel Grote 30.11.2009
Electricity Markets Regulation - Lesson 4 - Regulatory Asset Base
The allowed revenue for provision of regulated services includes the operating cost, depreciation and return on regulated assets. The return, if calculated as the allowed rate of return (cost of capital) is charged on the regulatory asset base. This session explains how to the regulated revenue is set and the role of regulatory asset base (RAB).
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1. Training on Regulation A webinar for the European Copper
Institute Webinar 4: Revenue Requirements and Regulatory Asset Base
(RAB) Dr. Konstantin Petrov / Dr. Daniel Grote 30.11.2009
3. 1. Introduction Price Control Regulatory Tasks Setting
revenue requirements / cost determination Decision on regulatory
regime Setting annual efficiency target Tariff design Webinar 4 -
Revenue Requirements and RAB Webinar 3 - Price Regulation Webinar 8
- Pricing Webinar 6 - Efficiency Assessment Calculation of
regulatory asset base Rate-of-Return, Cap Regulation, Sliding
Scale, Yardstick Competition Data Envelopment Analysis, econometric
approaches, reference network models Tariff structures, cost
allocation Webinar 5 Cost of Capital Calculation of allowed rate of
return
4. 1. Introduction Price Control Models
Rate-of-Return regulation
Prices / revenues based on operating costs plus fair
return
Price Cap and Revenue Cap regulation
Upper limit (cap) on prices or revenues
Efficiency targets
Regulatory period (3-5 years)
Price reviews
5. 1. Introduction Price Control Revenue Requirements
Regulators have to recognize the importance to regulated service
providers of recovering sufficient levels of costs. Failure to
include adequate costs as part of the revenue requirements may
discourage investments and deteriorate quality of supply. However,
it is important that the regulated service provider does not incur
excessive or unnecessary costs in providing services. Operating
Expenditures (Opex) Capital cost
Opex are the costs incurred by a regulated company in providing
the regulated services and maintaining and operating the relevant
assets
The recovery of opex does not provide any return to
shareholders and debt holders, as they are paid out in the form of
salaries, ongoing operating and maintenance costs, etc
Capital costs provide an annual recovery of the capital
expenditures (capex) undertaken by a regulated service provider in
providing the regulated services
Capital costs include depreciation allowance and return
6. 1. Introduction Price Control Revenue Requirements Opex
Capital costs Revenue Requirements Regulatory Asset Base (RAB) Rate
of Return Revenue Requirements = Opex + Depreciation + (RAB Rate of
Return) Operation and Maintenance Network Losses Fuel (in case of
regulated generation) Return on Assets Depreciation
Controllable OPEX (costs the company can influence and decide
upon) or
Non-controllable OPEX (costs beyond the control of the
company)
Only controllable OPEX exposed to efficiency analysis
The split between controllable and not controllable costs
depends on legal and regulatory framework, technical standards and
norms
8. 2. Revenue Components Depreciation
Systematic allocation of the investment cost to purchase an
asset (capex) over the period in which the asset provides benefits
to the regulated company (asset life)
There might be differences between depreciation for regulatory,
financial accounting and tax purposes
Depreciation can be calculated by using various asset valuation
methods (see next slides)
Typical depreciation methods are:
Straight-line method which allocates equal amounts of
depreciation to each accounting period of the asset life
Accelerated method (e.g. declining-balance) which allocates
decreasing amounts of depreciation to each accounting period of the
asset life
Most regulatory authorities apply straight-line method
9. 2. Revenue Components Depreciation straight-line method
declining-balance method time 10 years 20 years remaining asset
value Initial asset value depreciation time 10 years 20 years
remaining asset value Initial asset value depreciation
10. 2. Revenue Components Return on Assets Regulatory Asset
Base (RAB)
The Regulatory Asset Base (RAB) comprises the assets used to
provide the regulated services
Typically regulators apply the following principles for
RAB:
It includes only assets necessary to provide regulated
services
It is based on the residual (depreciated) value of fixed
assets
It may include allowance for net working capital
It excludes any capital contributions (external funding,
subsidies) from customers, government or third parties
11. 2. Revenue Components Return on Assets Rate of Return
The rate of return describes the return the regulated company
is permitted to earn (also known as the opportunity cost of
investor capital)
It is based on a weighted average of the cost of debt and
equity financing
There are several methods to calculate rate of return
The most prominent model to calculate the rate of return in
practice is the Capital Asset Pricing Model (CAPM)
The CAPM takes into account that investors need to be
compensated for the time value of moneyrepresented by the risk-free
rate and risk premium (beta)measured by the correlation between the
returns of the regulated company and market returns
What is included in the costs of capital and how it can be
calculated is addressed in detail in webinar 5
12. 3. Regulatory Asset Base (RAB) Components Regulatory Asset
Base Existing Assets New Investments RAB roll forward / revenue
re-setting Depreciation Capital Contribution Working Capital
Construction Works in Progress RAB Closing Value = RAB Opening
Value + Investments Depreciation Asset Disposal +/- Change of
Working Capital +/-Change of Capital Contribution
13. 3. Regulatory Asset Base (RAB) Investments (1)
An investment is incurred when a business spends money either
to buy fixed assets or to add to the value of an existing fixed
asset
Three types of investments may be considered:
Extension investments: investments needed for meeting the
change of load and generation patterns in the future
Replacements investments: investments related to replacement of
aged (technically or economically) equipment
Exceptional investments: investment resulting from new legal
obligations for example
(e.g. if new labour safety rules require safety measures in
substations or high voltage pylons, this probably leads to
investments)
14. 3. Regulatory Asset Base (RAB) Investments (2) Regulatory
assessment of investments ex-ante ex-post
Assessment of adequacy and efficiency of companys proposed
investment program for the forthcoming regulatory period
Regulator asks regulated companies to submit their capital
expenditure projections
Companies get security that investment will be approved by the
regulator before investment is carried out
Supplement to ex-ante investment reviews (identify differences
between allowed and actual investments)
Or undertaken without previous ex-ante approval (e.g. hindsight
efficiency assessment like in Germany)
Companies face uncertainty of whether undertaken investments
will be recognised by regulator ex-post
Threat that investments may be rejected, or partially
disallowed - may provide an incentive to only undertake efficient
investment, but may also discourage investment
15. 3. Regulatory Asset Base (RAB) Construction Work in
Progress
Treatment of assets in construction
Long debates between regulators and regulated companies on this
issue
Some regulators include construction work in progress (CWIP) in
the RAB only after completion of construction
Other authorities base the inclusion of CWIP on other factors,
such as
whether the construction projects are of short duration
whether the investment in the project is so significant that
its exclusion could impair financing
whether the interest charged to construction represents a
substantial portion of the companys earnings
Some form of recognition of cost of capital committed during
construction appears appropriate
16. 3. Regulatory Asset Base (RAB) Working Capital
If the time at which a particular cost is incurred is different
from the time of its recovery (via tariff revenues), capital is
required to cover the time lag which is associated with a cost
Working capital defined as current assets minus current
liabilities
Regulatory treatment of working capital
Allowance for working capital to meet short-term obligations of
regulated companies
Consideration should be given to the use of a good-practice
target, to calculate a working capital allowance designed to give
companies an incentive to manage working capital well
17. 4. Asset Valuation Different Approaches Asset Valuation
Methods Cost based Value based Indexed historic cost Replacement
cost Historic cost Optimised replacement cost DCF value Deprival
value Market value
Asset valuation must be considered with regard to functional
adequacy and market value of regulated assets
Different methods involve varying degrees of effort to
calculate, give significantly different estimates of the regulatory
asset base (RAB), and also differ in their pricing and investment
signals
18. 4. Asset Valuation Historic Cost
Values assets at original purchase price (including any
relevant set-up and financing costs)
Advantages:
Administratively efficient, can be easily audited because the
data should be available from financial statements
Relatively inexpensive: does not require experts to determine
costs
Objective because it relies on actual data rather than
judgements
Disadvantages:
Understate asset prices in times of high inflation and
overstate asset prices in times of technological change
May lead to unstable prices (e.g. prices may rise when new,
more expensive assets replace existing assets)
Data may be inadequate (especially for assets that have been
acquired a long time ago)
Returns may be inadequate to support the funding of new
investments
19. 4. Asset Valuation Indexed Historic Cost
Historic asset values are adjusted upwards for the effect of
inflation
Value of the RAB is adjusted (increased or decreased) to
reflect changes in the underlying inflation index
Debate as to whether the index chosen should reflect price
changes in the particular industry under examination, or price
changes in the economy as a whole
Advantages and disadvantages similar to historic costs
20. 4. Asset Valuation Replacement Cost
Calculates the cost of replacing an asset with another asset
(not necessarily the same) that will provide the same services and
capacity as existing asset
Asset values are based on what it would cost to replace the
asset today
Advantages:
Assets are valued in current prices, which may provide an
incentive for efficient investment decisions
Allows regulator to reduce value of assets once it becomes
aware that a more efficient low-cost alternative asset is
available
Disadvantages:
Entails a degree of estimation and judgment
Information is more expensive to collect than historic cost
data because it may require expert advice (e.g. from engineers and
accountants) on a number of assets
May lead to higher prices and face political opposition
21. 4. Asset Valuation Optimised Replacement Cost
Values RAB on the basis of replacement cost of optimised
assets, which most efficiently reproduce the capacity and service
levels of existing assets
Removes inefficiencies in the RABs current asset configuration,
such as duplication, excess capacity and redundant assets
Advantages:
Eliminates inefficiencies in the existing assets
Disadvantages:
Relatively complex to implement, requires considerable input in
terms of manpower and financial costs
Requires a degree of subjective judgement about the optimum
configuration of assets in the RAB, and about the processes of
optimisation
22. 4. Asset Valuation Market Value
Values RAB on the basis of the price that would be obtained
from selling the assets in a competitive market
Advantages:
Uses the market to obtain the asset value
Avoids subjectivity in the asset valuation process
Disadvantages:
In many cases there is no indication of market value (share
quotation) of regulated companies / services
Even if there is a price indication based on a divesture /
privatisation of a regulated company, there may be no or
insufficient competition
23. 4. Asset Valuation DCF (Discounted Cash Flow) Value
Values RAB on the basis of the discounted cash flows of the
regulated company
Predicts the cash flows that the company is expected to
generate, and then discounts them back to present values using the
appropriate risk-adjusted discount rate
Disadvantages:
Requires assumptions and forecasting to estimate future cash
flows
Circularity problem arises because the future cash flows will
determine the value of the RAB, however the future cash flows
depend on the value of the RAB
The deprival value of an asset can be defined as the lower
level of its:
Replacement cost (if it can be replaced) and
Recoverable value
The recoverable value of an asset can be defined as the higher
level of:
The value that the company could receive for selling the assets
(value in exchange)
The value that the company could create by using the asset
within the business (value in use determined by the future cash
flows)
If the recoverable amount exceeds the replacement cost, and the
company was then deprived of the asset, it would buy another to
replace it if possible.
25. 4. Asset Valuation Deprival Value (2)
The replacement cost sets a maximum on the loss that the
company would suffer through the deprival
Where the recoverable value is less than replacement cost,
replacement of the asset would not be justified
Advantages:
Discourages inefficient investment
Provides information on the economic value of the RAB
Disadvantages:
Complexity
Requires assumptions and forecasting to estimate future cash
flows
Circularity problem arises because the future cash flows will
determine the value of the RAB, however the future cash flows
depend on the value of the RAB