Integration of capital expenditure in the price control

Transcription

1 Integration of capital expenditure in the price control Prepared by Andrew Tipping Economic Consulting Associates

2 Outline 1. Introduction 2. Reminder of the price review process 3. Role of RAB and capital expenditure a) Measuring RAB b) Adjusting RAB: for capex, disposals, depreciation, inflation 2

3 Introduction 3

4 Who is ECA? ECA provides economic consulting advice in infrastructure services for utilities, investors, regulators, and governments worldwide 20 years in business 60+ assignments annually 15+ years average experience 24 Consultants 100% Employee owned 40+ Utilities and regulators advised 65+ Countries worked in 4 Regional representations 6m Annual turnover 4

5 Reminder of the price review process 5

6 Service Standards A refresher on the price review process Existing Assets + = Regulatory Asset Base (RAB) x Reasonable = Rate of Return Target Return on Assets New CAPEX + = Allowed Revenues Depreciation/ Capital Maintenance + Operating and Maintenance Expense Customer Categories Tariff Structure 6

7 Role of RAB and capital expenditure Measuring RAB 7

8 Some reminders on the Regulated Asset Base It has various names: Regulated Asset Base (RAB), Regulatory Capital Value (RCV), Regulatory Asset Value (RAV) Assets used to carry out regulated activities Determined by the regulator may diverge from accounting values How is it used in the allowed revenue calculation? To cover financing costs of the regulated activities To recover the capital costs of investment in assets necessary to carry out the regulated activities, over the useful life of the assets 8

9 Principles for measuring the Regulated Asset Base The estimated number needs to satisfy: Fairness to consumers (affordability) Consumers should not pay excessively used and useful? Operational efficiency The system should operate at efficient levels and generate price signals that encourage efficient investment Fairness to utility/investors Investors need to earn a fair return on their investment Additionally, the following are desirable: Objectivity Comparability The objectives are often conflicting! The prioritisation of criteria will determine the method. 9

10 An overview of the asset measurement process Establishing the value of every single asset cumbersome Define broad asset categories For each category, define: Initial RAB value Remaining asset life Standard asset life 10

11 There are a range of approaches to measure RAB Cost based approach Most common, based on cost estimation of the assets Historical cost: Focused on fairness original purchase price less cumulative depreciation Current cost: Focused on operational efficiencyinvestments needed to replace existing assets Economic value measures Based on the Net Present Value (NPV) of future earnings Deprival value measures The lesser of economic value and replacement cost Notional value measures A conceptual asset base, not based on physical assets Calculated under a TotEx approach 11

12 How do we compare Historic and Current Cost Accounting? Historic cost accounting Value at the price paid for the assets (or approved at the time) when commissioned Investors should recover, and customers should pay, the actual costs of the investment made This is represented by the historic cost of purchasing the assets Current cost accounting Value at the current cost of purchasing the assets, ignoring their historic cost Economic efficiency requires that customers pay the costs of providing the service at this point in time Rapid cost and technology changes mean that historic costs of assets are a poor guide to their current costs 12

13 How do we set current costs? Inflation indexation Adjust historic asset values using a cost index (eg, CPI, PPI) Replacement cost Revalue at the current cost of purchasing the same asset what is the cost that a new entrant would pay to enter the market? Is this a fair question? Modern Equivalent Asset (MEA) Revalue at the current cost of replacement with an asset of the same capability Optimised replacement cost ( reference utility ) Determine the optimal network design required to deliver the same level of service and value this at current costs 13

14 Cost-based measures Historical cost Also known as depreciated actual cost: original purchase less cumulative depreciation Costs actually incurred by the company. Apply when: Significant scope for new entry Charging methodology not flexible enough to produce efficient price signals objective data-based simple Pros audits easy if data available avoids windfall gains or losses for the company data availability Cons divergence from current market price over time due to inflation and technological progress 14

15 Cost-based measures Replacement cost Cost of replacing existing assets with different assets that provide same service and capacity Hypothetical costs incurred by a new entrant Most commonly used to value privately-owned utility businesses Pros theoretically, a close representation of asset market value Cons expert advice from engineers and accountants may be needed subjective Optimised replacement cost- adopt the replacement cost methodology with a focus on efficiency improvement, assumes a new entrant perspective Pros closer to the market value as the optimisation procedure mimics competitive market Cons subjective- often efficient to establish excess capacity that will take years to absorb 15

16 Economic value-based measures Current economic value of the assets or value in use What value does the asset generate for the utility? For a given asset, determine the greater of the net present value (NPV) and the scrap value of the asset Pros incentivises the scrappage of inefficient assets Cons requires estimates of future profits circularity issue: anticipated revenue NPV of future profits opening RAB maximum allowed revenue (MAR) anticipated revenue 16

17 Economic value circularity Economic value is the PV of future cash flows Future cash flows comprise three parts Two of those parts are based on the economic value OpEx Return on capital Return of capital 17

18 Deprival value measures Compare replacement cost (RC) and economic value (EV) and choose the lower one Pros helps determine assets that cost more than their economic value Cons all issues of EV and RC Optimised deprival value (ODV) compare optimised replacement cost (ORC) and economic value (EV) and choose the lower one Pros ORC more realistic than RC Cons all issues of EV and ORC 18

19 Service Standards Notional value (TotEx) measures Existing Assets + = Regulatory Capital Value (RCV; RAB) x Reasonable = Rate of Return Target Return on Assets Slow New CAPEX money + = Allowed Revenues Depreciation/ RCV/RAB Capital Run-off Maintenance + Operating PAYG and Maintenance Expenditure ( Fast Expense money ) TotEx Customer Categories Tariff Structure 19

20 Notional value (TotEx) measures RAB as a notional financial concept Utility can choose whether to recover expenses in one year ( fast money ), or over many years ( slow money ) Pros much easier to calculate RAB gives flexibility in determining tradeoffs between expenses now and in the future Cons subjectivity in trade-offs between current and future customers indirect relationship with financing so choices need to ensure financeability 20

21 Challenges in Replacement cost determination Generally requires detailed asset register showing age and condition of all existing assets of the utility Revaluation needs engineering consultants with comprehensive database and, for optimised values, power network planning tools No two consultants will have the same views, making it more difficult to reach agreement on valuations Difficult to transpose across countries (exchange rates, equipment specifications, design philosophies, environmental conditions, topography, service standards) 21

22 Comparing Historic and Current cost measures Historic cost accounting Transparency Simplicity Risk to utility (stranded assets) Risk to customers (over-payment) Economic efficiency (prices = marginal cost) Current cost accounting Inflation indexation Replacement cost MEA Optimised replacement cost 22

23 The need for consistency between asset valuation and returns If CCA is used, then the asset base is updated for changes in costs at each reset of allowed revenues Therefore, the allowed return needs to be calculated in real terms (ie, excluding inflation) The impacts of inflation have already been captured through the CCA adjustment to asset values If HCA is used, then the allowed return needs to be calculated in nominal terms (ie, including inflation) 23

24 Some additional points on RAB measurement How realistic is revaluation? Likelihood is for something based on historic (actual) costs Exclude grants or other assets the utility has not paid for (capital contributions) Working capital: the regulator might decide to consider an allowance for working capital to meet the short-term obligations of the regulated companies 24

25 Role of RAB and capital expenditure Adjusting RAB 25

26 Adjusting the Regulated Asset Base Periodic adjustments to the RAB have a typical calculation: Opening RAB + Approved Additions (capex or commissioned assets) - Disposals - Depreciation ± Inflation = Closing RAB 26

27 How should we determine the depreciation profile? From a regulator s perspective, the depreciation allowance has two purposes: Efficiency. Reflect the cost of customers consumption of assets implies using the technical life Financeability. Generate sufficient cash to service debts implies using lives close to the term of loans used to fund the assets These may conflict with each other Technical lives of assets can be very long for many network assets lives may be 40+ years This is much longer than the term of most loans that will be available. Therefore, avoiding financial difficulties requires either shortening the asset life or increasing the use of equity financing 27

28 There are different methods of depreciation from which to choose Straight line most common Assumes a linear relationship between accumulated depreciation and the age of the asset Involves systematic allocations that remain constant from year to year Accelerated front-loaded Front loaded, ie it is higher in early years, perhaps to assist finance repayment The reducing balance methodology yields allocations that decrease from year to year Per Unit based on asset utilisation Estimates total service provided by the asset and then allocates a charge each year Progressive very rare The depreciated amount increases each year Used to attract consumers to the business as tariffs low in early years of operation 28

29 Why use depreciation (v Capex, v financing)? CapEx Depreciation Financing

30 Understanding accounting and regulatory depreciation Accounting depreciation Set for tax reasons May bear little resemblance to the actual useful lives of assets Regulatory depreciation Based on the economic life of the assets (customers use of the assets) Allocatively efficient customers pay for the true cost of the services being provided Engineering consultancies often have large databases of asset life information from which to determine this 30

31 What is the purpose of inflation indexation in RAB adjustment? Indexation refers to the process of adjusting the RAB for the effects of inflation Inflation adjustment should be consistent with the method chosen for estimating RAB If RAB is based on costs today, then it has an implicit inflation adjustment already Allowed revenue adjustments should be on the same terms Trade-off between a single general index and industry-based indices Economy-wide index reflects changes in prices across the economy, so price changes will be comparable to a bundle of goods and services, so often a consumer-based index Industry-based indices will be similar to the replacement cost approach 31

32 Which inflation index to use? Regulators have tended to default to indexing costs to economy-wide inflation using the Consumer Price Index (CPI) This is obviously not necessarily a good proxy for changes in the costs of, for example, distribution cables and towers However, it has the advantages of being compiled and calculated independently of the utility and the regulator being publicly available, increasing transparency avoiding the inevitable disputes and calculation difficulties that would arise if the regulatory tried to determine their own inflation index 32

33 Adjusting RAB for capex Capex is added to the RAB when it is incurred/spent OR Capex is added to the RAB when it is commissioned, with the total value grossed up to account for returns on the asset during construction. Easier to administer because there are no complexities related to capex being incurred in one regulatory period but not commissioned until the next Consumers won t pay for capex that is not yet operational and will not be for some years ahead 33

34 THANK YOU FOR YOUR ATTENTION! Andrew Tipping W Web: