Electricity Markets Regulation - Lesson 4 - Regulatory Asset Base
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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
- 2. Agenda 2. Revenue Components 4. Asset Valuation 1.
Introduction 3. Regulatory Asset Base (RAB)
- 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
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- Upper limit (cap) on prices or revenues
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- Regulatory period (3-5 years)
- 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
- 7. 2. Revenue Components Operating Expenditures (OPEX)
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- Controllable OPEX (costs the company can influence and decide
upon) or
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- 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:
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- Straight-line method which allocates equal amounts of
depreciation to each accounting period of the asset life
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- 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:
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- It includes only assets necessary to provide regulated
services
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- It is based on the residual (depreciated) value of fixed
assets
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- It may include allowance for net working capital
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- 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:
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- Extension investments: investments needed for meeting the
change of load and generation patterns in the future
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- Replacements investments: investments related to replacement of
aged (technically or economically) equipment
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- Exceptional investments: investment resulting from new legal
obligations for example
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- (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
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- Long debates between regulators and regulated companies on this
issue
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- Some regulators include construction work in progress (CWIP) in
the RAB only after completion of construction
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- Other authorities base the inclusion of CWIP on other factors,
such as
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- whether the construction projects are of short duration
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- whether the investment in the project is so significant that
its exclusion could impair financing
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- 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
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- Allowance for working capital to meet short-term obligations of
regulated companies
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- 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)
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- Administratively efficient, can be easily audited because the
data should be available from financial statements
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- Relatively inexpensive: does not require experts to determine
costs
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- Objective because it relies on actual data rather than
judgements
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- Understate asset prices in times of high inflation and
overstate asset prices in times of technological change
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- May lead to unstable prices (e.g. prices may rise when new,
more expensive assets replace existing assets)
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- Data may be inadequate (especially for assets that have been
acquired a long time ago)
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- 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
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- Assets are valued in current prices, which may provide an
incentive for efficient investment decisions
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- Allows regulator to reduce value of assets once it becomes
aware that a more efficient low-cost alternative asset is
available
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- Entails a degree of estimation and judgment
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- 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
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- 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
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- Eliminates inefficiencies in the existing assets
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- Relatively complex to implement, requires considerable input in
terms of manpower and financial costs
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- 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
-
- Uses the market to obtain the asset value
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- Avoids subjectivity in the asset valuation process
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- In many cases there is no indication of market value (share
quotation) of regulated companies / services
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- 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
-
- Requires assumptions and forecasting to estimate future cash
flows
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- 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
-
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- (RAB - > Return on assets -> Revenue -> Cash
Flow)
- 24. 4. Asset Valuation Deprival Value (1)
- The deprival value of an asset can be defined as the lower
level of its:
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- Replacement cost (if it can be replaced) and
- The recoverable value of an asset can be defined as the higher
level of:
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- The value that the company could receive for selling the assets
(value in exchange)
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- 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
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- Discourages inefficient investment
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- Provides information on the economic value of the RAB
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- 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
-
-
- (RAB - > Return on assets -> Revenue -> Cash
Flow)
- 26. End of Webinar 4
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- Kurt-Schumacher-Str. 8, 53113 Bonn
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- Tel. +49 (228) 44 690 00 Fax +49 (228) 44 690 99
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- Mobil +49 173 515 1946 E-mail: konstantin.petrov@kema.com