The Valuation of Assets and Its Impact on Water Utility Pricing in Australia. Angela Tan-Kantor

Transcription

1 The Valuation of Assets and Its Impact on Water Utility Pricing in Australia Angela Tan-Kantor This thesis is submitted in fulfilment of the requirements for the degree of Doctor of Philosophy at Swinburne University of Technology

2 Declaration This thesis contains no material which has been accepted for the award of any other degree, except where due reference is made in the content of the thesis. To the best of my knowledge, this thesis contains no material previously published or written by another person except where due reference is made in the content of the thesis. Signed: Angela Tan-Kantor Dated: 20 August

3 Glossary Introduced terms: blocks buffer building block CPI-X deprival value economic worth free allowances gold-plating greenfield holding gains inclining block tariffs law of the lands line in the sand lumpy modern engineering equivalent assets money items money worth moral hazard newnormal one size fits all operating capability optimised out rate base rebalancing regulatory period risk premium scrap value standards sunk use and useful value to the owner Abbreviations: A B C Accounting information systems (AIS) Adelaide Desalination Plant (ADP) AGL Gas Networks Limited (AGLGN) Agricultural and Resource Management Council of Australia and New Zealand (ARMCANZ) Aqwest-Bunbury Water Board (AQWEST) Australian Accounting Research Foundation (AARF) Australian Accounting Standards (AAS) Australian Accounting Standards Board (AASB) Australian Competition and Consumer Commission (ACCC) Brisbane Water (BW) Busselton Water Board (BWB) Capital Asset Pricing Model (CAPM) Constant Purchasing Power Accounting (CPPA) Consumer Price Index (CPI) Continuously Contemporary Accounting (CoCoA) Council of Australian Governments (COAG) Current cost accounting (CCA) 3

4 D E F G H I K M Depreciated actual cost (DAC) Depreciated inflation historical cost (DIHC) Depreciated optimised replacement cost (DORC) Depreciated replacement cost (DRC) Drought response strategy (DRS) Economic Regulation Authority (ERA) Economic value (EV) ESC of South Australia (ESCOSA) Essential Services Commission (ESC) European Accounting Association (EEA) Fair value accounting (FVA) Financial Accounting Standards Board (FASB) Fitzroy River Water (FRW) Generally Accepted Accounting Practices (GAAP) gigalitre (GL) Gladstone Area Water Board (GAWB) Gold Coast Water (GCW) Government Prices Oversight Commission (GPOC) Gross domestic product (GDP) Historical cost accounting (HCA) Independent Competition and Regulatory Commission (ICRC) Independent Pricing and Regulatory Tribunal (IPART) Independent Procurement Entity (IPE) International Accounting Standards Board (IASB) International Financial Reporting Standards (IFRS) kilolitre (kl) Maximum allowable revenue (MAR) Megalitre (ML) Ministry of Economic Development (MED) Modern engineering equivalent assets (MEERA) Modern equivalent asset (MEA) 2

5 N O Q R S U W National Competition Council (NCC) National Competition Policy (NCP) National Water Initiative (NWI) Net present value (NPV) Net realisable value (NRV) NWI Commission (NWIC) Operating and maintenance expenditure (OPEX) Optimised deprival value (ODV) Optimised replacement cost (ORC) Qualitative Characteristic (QC) Queensland Competition Authority (QCA) Redlands Water & Waste (RWW) regulatory asset base (RAB) South Australia Water Corporation (SA Water) South East Queensland Water Corporation Limited (SEQ Water) Standing Committee on Agriculture and Resource Management (SCARM) Steering Committee on National Performance Monitoring (SCNPM) Sydney Desalination Plant (SDP) Upper revenue bound (URB) Water Industry Regulatory Order 2003 (WIRO) Water Services Association of Australia (WSAA) Weighted average cost of capital (WACC) 3

6 Table of Contents Glossary... 3 Acknowledgements Abstract Chapter One: Introduction Background and context Infrastructure assets Issues Research problem Research methodology Contribution to knowledge Structure of thesis Chapter Two: Characteristics of Urban Water and Current Water Pricing Approaches Introduction Main characteristics of water The urban water industry What is a regulation? Why is regulation important? Rationale for regulation How to regulate Economic efficiency and principles of efficient prices Approaches to urban water pricing The current urban water pricing approach The current water pricing arrangements Background of regulatory models Price and revenue caps individual price caps Weighted average price cap (or tariff basket) Weighted average revenue cap Revenue cap Summary Chapter Three: Literature Review Introduction The rationale for HCA The rationale of CCA The rationale of value-based accounting method NRV The rationale of value-based accounting method NPV

7 3.6 The rationale of FVA : The rationale of the use of ODV in utility businesses Summary of main types of asset valuation techniques used across various assets Survey and case study on asset valuation and pricing Definitions of natural monopoly Foundations of price regulation Effects of rate regulation and price on utility businesses Summary Chapter Four: The Urban Water Industry in Major Australian Cities Introduction New South Wales The industry Governance of urban pricing Water supply Supply demand balance Water and sewerage reform Victoria The industry Governance of urban pricing Urban wholesale water providers Urban retail water providers Water availability Supply demand balance Water and sewerage reform Queensland The industry Governance of urban pricing Water supply demand balance Water and sewerage reform South Australia The industry Governance of urban water pricing Water supply Water and sewerage reform Western Australia The industry Governance of urban water pricing

8 Water availability Water supply Supply demand balance Water and sewerage reform Western Australia water and sewerage reform A separate procurement entity Tasmania The industry Governance of urban water pricing Water availability Water supply Supply demand balance Water and sewerage reform Summary Chapter Five: Urban Water Regulation and Pricing Introduction Water pricing and institutional reform New South Wales Building block approach to determining revenue requirement Return of capital Return on capital Victoria Overview on ESC s approach to assessing water plans Overview of revenue requirement The ESC s assumptions Operating expenditure Capital expenditure Financing capital investments Regulatory asset base Rate of return Regulatory depreciation Final decision Queensland Pricing principles and methods Methodology: maximum revenue requirement Regulatory asset base Return on capital

9 Weighted average cost of capital Return of capital Operating costs Two-part tariffs Pricing water New developments South Australia Overview Cost recovery of capital expenditure Urban water tariffs Ongoing business viability Overview of revenue requirement Regulatory asset base Capital expenditure Rolling forward asset values Return of assets depreciation Operating, maintenance and administrative costs Western Australia Key findings on Western Australia Water Corporation s revenue requirement operating expenditure Capital expenditure Depreciation Rate of return Initial RAB Tasmania The building block approach Operational, maintenance and administrative costs Asset consumption costs Highlighted reforms of Tasmania s water and sewerage sector Summary of water pricing and economic regulation Summary Chapter Six: Asset Valuation Techniques Used in Water Utility Businesses Introduction Recognition and measurement of assets Asset valuation Role of asset valuation and regulatory control issues What is deprival value?

10 6.6 Background information of the ODV Overview of asset valuation techniques Summary Chapter Seven: Asset Valuation Method Using the ODV Introduction Brief overview of the CCA Developments of the deprival value in Australasia The O in the ODV Steps involved in ODV System optimisation Valuation of the ODV at EV Summary Chapter Eight: Research Methodology Introduction Research methodology Overview of accounting research Accounting research methodologies The case study methodology to this thesis The exploratory case study methodology to this thesis Step 1: Determine and define the hypothesis of the thesis Step 3: Determine data gathering and analysis techniques Step 4: Collect data in field Step 5: Evaluate and analyse data Step 6: Prepare the report Summary Chapter Nine: Results and Discussions Introduction Comparison of pricing-based asset valuation techniques Justifications for the findings Case studies in water industry New South Wales Victoria Queensland South Australia Western Australia Tasmania Key findings

11 9.5 Regression analysis Summary of current institutional structure arrangements Water Pricing Principles as outlined by the NWI Summary of asset valuation techniques used by water utilities in major Australian jurisdictions Is the price of water high or low? Summary Chapter Ten: Summary and Conclusions Introduction Outline of the thesis Limitations of the research Suggestions for future research Summary References Appendix 1: Examples of Optimisation Appendix 2: Water Price Structures

12 Acknowledgements I would like to express my gratitude to all those who made it possible for me to complete this thesis. Without the supportive academic and research environment at Swinburne University of Technology, Faculty of Business and Enterprise, Hawthorn, (formerly Faulty of Higher Education, Lilydale) the completion of my thesis would not have been achievable. I owe a debt of gratitude to Associate Professor Malcolm Abbott for his encouragement, guidance and support throughout this research project. Thank you for your patience in reading all my draft chapters. Without your expertise and suggestions, I would not have completed this thesis. I would also like to express my gratitude to staff from the Faculty of Business and Enterprise, Hawthorn, in particular to Head of Academic Group, Dr Mary Dunkley, for her continuous support, especially at the time of the writing of the thesis. Thank you to Professor Christine Jubb, Associate Professor Jean Raar, Senior Lecturer Judy Oliver and Senior Lecturer Dr John Lourens for the feedback and assistance they provided for this thesis. Thank you and appreciation is also extended to my colleagues, in particular Dr Sarod Khandaker, Dr Omar Bashar, Dr Craig Macintosh and Dr Jason Skues who willingly availed me of their expertise. Finally, I am thankful and forever indebted to my family for their understanding and patience throughout this thesis project. 10

13 Abstract In Australia, asset valuation is used to determine a rate base that helps regulate water prices using the building block approach. Different asset valuation techniques result in significantly different figures for the same assets, and will lead to different levels of water prices affecting consumers and investors behaviour in the industry. Using the exploratory case study research methodology and regression analysis, the thesis is the first study undertaken that explores the use of deprival value, an accounting measurement concept developed for the purpose of determining the initial value of regulatory asset base (RAB). The RAB is an accounting figure and asset valuation used for price-setting purposes. Under the deprival value method, two main asset valuation techniques are used for price-setting purposes; that is, the depreciated optimised replacement cost (DORC) and economic value (EV) valuation models, in context of water utility pricing in major Australian jurisdictions. A common understanding is established to justify as to why the two main techniques stand as the recommended asset valuation techniques for the pricing of water in Australia. In undertaking this research, academics and practitioners will be able to better judge whether DORC or EV principles are well suited for tariff regulation and whether the financial models can be transported usefully to other price-setting and financial modelling applications, whether in the public or private sector or both. 11

14 Chapter One: Introduction 1.1 Background and context Utilities (including electricity, gas, water and wastewater) provide essential services. According to the Australian Bureau of Statistics, the industry employed 1.2 per cent of the total Australian workforce and contributed 2.3 per cent or $25.3 billion to the nation s gross domestic product (GDP) in (Australian Workforce and Productivity Agency 2013, p. 1). A key feature that distinguishes the Australian environment from that of other countries is that water is a scarce resource relative to its many uses. Australia is the driest inhabited continent on Earth, and yet it is among the world s highest consumers of water as reported by the Australian Natural Resources Atlas (2000, p. 8). On a per capita basis, each Australian uses an average 1.31 million litres of water each year; leading to an average total of gigalitre (GL) of water used in enough water to fill Sydney Harbour 48 times (one GL is litres). A more recent record reveals that each Australian household uses an average of 350 litres of water per day, of which gardening is responsible for up to half, while flushing toilets accounts for approximately one-quarter. In comparison, consumers from Asia, Africa and Latin America use litres per day, while in the United States they use approximately litres. Out of the GL water, GL (80 per cent) comes from rivers and dams, and GL (20 per cent) is groundwater. In Australia, 75 per cent of water is used for irrigated agricultural, 20 per cent for urban and industrial purposes, and 5 per cent for domestic purposes (Agriculture, Fishery and Forestry Australia 2000, p. 2). Rainfall is the best available source for water, but according to the Australian Bureau of Statistics (2012, p. 83), the years 2001 to 2009 were the driest ever over parts of eastern Australia. Droughts in south east Australia (southern Queensland, New South Wales, Victoria, Tasmania and parts of South Australia) and south west Western Australia were most economically damaging, since 75 per cent of Australia s population and its agriculture are located in these areas. As a consequence of below-average rainfall, 12

15 restrictions have been implemented in many cities and most irrigation areas on usage of water by households and industries (including agriculture). Droughts can have a severe economic impact. For example, it was estimated to have had a downward impact on GDP of almost 1 percentage point between and , while the drought had a downward impact of 0.6 per cent (Australian Bureau of Statistics 2012, p. 83). At present, the price of water is a focus of intense interest to Australian states and territories, national governments and the general public. Water is an essential basic component of all life; no life (human, animal or plant) can live without it. The setting of water prices (rates) affects not only the cost of living for many other goods and services, but also the general cost of living for ordinary citizens. Water is a critical and necessary resource for Australia. On its own, it is a major enabler of economic activity. Most importantly, water is a predominant economic sector in its own right and is essential to maintaining a high living standard for all Australians. The availability of reliable and affordable water must therefore be provided to all citizens. It underpins the success of future Australian cities. In a broader context, the supply of water (and infrastructure) is one of the cores of social and economic development in Australia. Therefore, as water scarcity grows, it is more important than ever to fully account for water stored, traded and consumed, to ensure sufficient investment is made in water infrastructure to secure supplies. National investment in water supply and wastewater disposal related infrastructure is an important part of government policy, given that the industry is heavily regulated and the bulk of physical assets are government-owned. Investment in water is important, not only for ensuring the viability of bulk water supplies from dams and other sources (e.g. recycling and desalination plants), but also for reducing losses from leakages and overflows. 13

16 1.2 Infrastructure assets From storage, water is typically distributed across a wide network of pipes. In Victoria, for instance, most of Melbourne s water catchments are in forested areas high in the eastern and north eastern ranges. Here the rainwater is caught, held and filtered as it flows into streams and reservoirs, where it is stored for long periods. Then with the help of large pipes (distribution mains), water flows to service reservoirs, from where it is distributed to the metropolitan retail water businesses via small pipelines, reaching the ultimate consumer. For the company South East Water in Melbourne, km of largely underground pipes carry the water through a complex network. Water infrastructure assets include dams, weirs, barrages, pump stations, channels, pipelines, reservoirs, balancing storages, fish ways and water meters that measure the water going in out and out of the system. Other assets include electrical and mechanical equipment to make it fully functional. An example of recent important investment in water infrastructure is the enlarged Cotter Dam, one of the biggest construction projects undertaken in the Australian Capital Territory, which aims to extend the current Cotter Dam downstream, increasing its current capacity from 4 GL to about 78 GL almost 20 times its current size. The enlarged Cotter Dam project will be a part of the Australian government s continued response to ensure a secure water supply for the Australia Capital Territory, and to deal with drought, climate change and its variability. Construction was completed in 2013, at a total cost of $363 million (ACTEW 2011). Another recent water project was the Murrumbidgee to Googong pipeline in the Australian Capital Territory. The one-metre diameter pipeline of this project transfers up to 100 megalitres per day (ML/d) of raw water from Murrumbidgee River near Angle Crossing to a pipeline running via the Burra district to Googong Reservoir. The project was valued at almost $155 million and was completed in August It was quoted in the Canberra Times that the engineering projects in the Australian Capital Territory in were worth $760 million at prices (Downie 2011, p. 2). 14

17 The South East Queensland Water Grid is another project that was one of the largest of its time and was built in response to the drought that affected water supplies in Brisbane and surrounding areas between 2004 and Its bulk water assets include twelve connected dams, ten connected drinking water treatment plants, three advanced water treatment plants producing purified recycled water, one desalination plant, twenty-eight water reservoirs, twenty-two bulk water pump stations, and 535 km of potable bulk water mains that connect areas with water to areas lacking water. The South East Queensland Water Grid project cost $6.9 billion (Queensland Government 2010). Another project, the Western Corridor Recycled Water Scheme which is located in South East Queensland, was constructed in 2006 and completed in Three advanced water treatment plants were constructed at Bundamba, Luggage Point and Gibson Island, where water is drawn from six existing wastewater treatment plants to produce up to 232 million litres of purified recycled water daily. A network of pipelines over 200 km long distributes water to consumers. The Australian Government funded $408 million through its Water Smart Australia Program. The Western Corridor Recycled Water Scheme was Australia s largest recycled water project, which cost $2.5 billion (Queensland Government 2010). Finally, Australia s largest, indeed the Southern Hemisphere s largest desalination plant, is located in Victoria at Wonthaggi, and the cost of this project was $3.5 billion. The Wonthaggi Desalination Plant supplies 30 per cent of Melbourne s water needs (State of Victoria Government 2009, p. 2). 1.3 Issues Australia has a public policy of open access and regulation of infrastructure assets that are regarded as possessing natural monopoly characteristics. The principal features of natural monopoly industries include large fixed and sunk costs, and economies of scale over the relevant range of demand for the service. With an expansion in demand, it might be possible to achieve efficient production through an increase in the number of firms (providers) (Fearon 2006, p. 2). Lee and Fisher (2004, pp ) stated from a financial accounting perspective that infrastructure assets are defined as all non-current 15

18 assets including the public facilities which provide essential services and enhance the productive capacity of the economy. This is the case whether the assets are government or privately-owned and include roads, bridges, railroads, power generations and distribution networks and in particular water supply and sewerage systems. Water supply is generally regarded as having natural monopoly characteristics, which means that it can also be subjected to economic regulation of prices and revenue, in turn influencing levels of investment. In Australia, the water supply and wastewater businesses are regulated by state government-based bodies, such as the Essential Services Commission (ESC) in Victoria, and the Independent Pricing and Regulatory Tribunal (IPART) in New South Wales. This is in place of national bodies such as those that exist for other utilities like telecommunications, electricity and natural gas. In undertaking this regulation, state-based bodies depend upon using a range of accounting methodologies to determine what is regarded as being fair prices to both consumers and investors/owners. These prices are determined with the aim of ensuring a fair rate of return to investors, at levels that do not exploit consumers. Formal regulation of this type also exists in other countries including the United Kingdom and United States. Abbott and Cohen (2010, p. 48) noted that in Australian capital cities, public ownership and operation of water supply assets is still the norm; although a noteworthy exception to this is Adelaide where the system is state-owned but operated by a private company. Public ownership has endured for a number of reasons, including high interest in environmental and quality standards, as well as water supply security issues. One additional reason, perhaps, is that there have not been any large-scale success stories of water privatisation overseas, unlike other industries such as telecommunications. Current regulatory measures that rely upon the application of accounting methodologies were not entirely intended for the purpose of determining asset valuation and depreciation schedules. To add to this, there is no complete consensus on which techniques can be used across Australian states and territories, or even internationally. Instead, for the purpose of charging (pricing), the deprival value is used along with historical costs and replacement costs in some overseas jurisdictions. 16

19 1.4 Research problem In competitive markets, the buyers and sellers do not need to go through the process of establishing a price for a particular good or service. Market forces determine demand and supply, and price, and hence also the asset values. Unlike in the competitive markets, the provision of services by the water industry has natural monopoly characteristics (free from direct competition), which means consumers cannot change water providers. It is more efficient in terms of cost-technology for production to be served by a single and large supplier of the entire market. Water businesses charge their customers with regulated rates (prices) within a defined geographic service area. They must provide water services within their defined jurisdiction and expand their capacity, finding alternative ways to source water as demand for water services increase, or where rainfall decreases due to prolonged drought and low dam inflows. The operating and regulatory environment in relation to issues such as pricing, licensing, health and environmental standards for drinking water supply, wastewater treatment and disposal from where a water utility business operates is different to other non-regulated, mainstream businesses in Australia. Water infrastructure assets such as dams, pipelines and sewerage treatment plants are rarely, if ever, sold in Australia. Given that they do not have any alternative use and many are government-owned, they are unlikely to attract potential buyers under the present regulatory conditions. Both water retailers and customers pay for the transmission and distribution of water services and prices within the tariff setting activity in regulated water utilities. The final decision on water prices lies in the hands of the regulators, and over many decades regulatory bodies in Australia have faced this fundamental issue in many different contexts. Government regulation and the pricing of utilities in the free market continues to be a questionable issue that is strongly debated by all parties, including academics, researchers, regulators, utility businesses and customers. 17

20 The most significant impact on the average price of water is the regulatory asset base (RAB), an accounting figure that determines the value of all new and old physical assets funded directly by the business, to which customers are required to pay for water and services. The RAB value is an asset valuation, and it is set in periodic review and fixed during the regulatory period of three to five years. The RAB drives three-quarters of the revenue requirement of a water business and is considered the key determinant of performance; it has the ability to turn revenue into profit, which in turn determines prices. In recent years, desalination plants were built in major capital cities including Sydney, Melbourne, Adelaide and Perth, to reduce the reliance of urban water supplies on rainfall. This thesis examines the impact of capital expenditure (investment of new assets) on RAB, revenue requirement and the price of water derived based on these figures. If prices, revenue and profits are dependent on the value of a RAB, and investment is determined by levels of productivity, then the asset valuation techniques have a vital role, not only in relation to consumer pricing, but also the return to owners and the long-term investment of the industry. A water business such as South East Water in Melbourne is considered a capital-intensive industry, with a minimum decline in book value of its asset. A large portion of capital is used to buy expensive new assets (e.g. pipelines, pumping stations and storage tanks), to replace existing ageing assets, and to expand the stock of assets so as to meet increasing demands, standards and regulatory obligations. The issue of asset valuation for water businesses is of critical importance, as it is the principal component in the building block approach to pricing. Zauner (2000, p. 1) claimed that asset valuation determines up to 80 per cent of the maximum allowable revenue (MAR) when applied. The valuation of assets has major consequences for defining the total costs of providing relevant services, and the determination of water prices that will be passed on to customers. In other words, asset valuation has a significant potential impact on the pricing of water. In accounting there is minimal consensus on the preferred asset valuation approach that should be adopted, as reflected in Australian and international accounting standards, 18

21 where a variety of measurement techniques are permitted as long as they are within the guidelines. There have been many debates on asset valuation techniques in terms of regulation and financial accounting. The controversy surrounding asset valuations is often not only inconclusive but also confusing; one of the reasons is that there are different implicit understandings of the underlying conceptual framework, if there is any such framework. The deprival value method, also known as value to the owner was originally recommended in Australia by some government authorities for the purposes of determining water utility businesses revenue requirements. This method is described in the National Water Initiative (NWI) Pricing Principles, an agreement made in 2004 by the Council of Australian Governments (COAG) and the Standing Committee on Agriculture and Resource Management (SCARM) (National Competition Council 1998, p. 112). Both the COAG (National Competition Council 1998, p. 112; Australian Government 2009, pp. 4 5 & 7) and the SCARM (National Competition Council 1998, p. 112) have recommended this method for valuation of water business assets. The deprival value is described as the value of any asset to the business; that is, how much the company would be worse off if it were deprived of the asset s sale, or it being worn out after years of use as a non-current asset. The use of deprival value has been promoted in many Australian Government policy documents as the appropriate current value basis for valuation of its publicly held assets (Lee & Fisher 2004, pp ). It is essential that a common understanding be established to justify why the deprival value stands as the recommended method. Similar but limited work has previously been done on energy (electricity and gas) businesses in Australia (Johnstone 2003, pp. 1 41). Yet even though comparisons have been made on the use of deprival value and depreciated optimised replacement cost (DORC) approaches in Australia s energy infrastructure, this has not been done for water infrastructure assets. This is regrettable, because water does not face the same conditions as electricity and natural gas, as it instead depends upon climatic conditions, and fixed infrastructure makes up a much more significant proportion of assets (Abbott & Cohen 2009, p. 48). 19

22 1.5 Research methodology The exploratory case study research methodology was applied in this thesis, which produces an invaluable deep understanding and insightful appreciation of the cases. The end result provides issues and challenges about the behavior of the RAB, its meaning and the effect it has on water pricing. In this thesis, the case study research methodology is used to explore and test the existing theories, such as the building block approach from which water prices are determined, and the upper- and lower-bound pricing principles described in economics and by the NWI Pricing Principles. The data collection methodology used consists of archival (secondary data) and quantitative (numerical). The three case studies described in this thesis are in Chapters Four, Five and Nine. The methodology in this thesis follows the approach used by the energy (electricity and gas) industry, in that it uses case studies to analyse the impact of using different asset valuation techniques in water regulatory pricing decision-making. The case studies include examples from all jurisdictions of Australia. Simulations of different asset valuation techniques are taken from electricity and gas companies because of the lack of experience and comparison of asset valuation techniques in the water industry. In doing so, these asset valuation techniques closely match those of the real-world results. In Chapter Nine, regression analysis is used to test the relationships between the dependent variable, capital expenditure and independent variables, asset valuation, length of pipes connecting residential properties water supply, and the amount of the population connected to urban water services. Data are collected from the Water Services Australia Association (WSAA) website, and water businesses industry reports over eight years from 2004 to 2012 are used to predict the behaviour and value of the dependent variable, capital expenditure. The hypothesis of this thesis is to test to see if there is a direct relationship between: (i) (ii) investment in water assets; does (i) impacts on the price of water and the RAB 20

23 The thesis will test to see if a relationship exists between asset valuation techniques (independent variable), prices, profitability and investment levels (dependent variable) in the industry, as well as the industry s long-term viability. 1.6 Contribution to knowledge In recent times, the price of utilities (water) has been one of the most critical and widely discussed issues. In particular, the increasing cost of water services has caused the price of water to increase, resulting in the existing rate-making process being questioned, reexamined and criticised. In addition, one of the most controversial and problematic issues in public utility economics-accounting is the fair return to owners. It represents a growing and major concern, not only to regulators but also to utility businesses and customers. Of primary importance in the regulation of network utilities is that they are natural monopolies, and yet they must be able to generate efficient pricing. Water prices are proposed by a water business, and then assessed and approved by its regulator. The price of water that consumers pay provides the total revenue of the water businesses, and reflects a fair and reasonable cost incurred by them, including a rate of return on the RAB. The price of water must be high enough to provide businesses (and their owners) with a fair and reasonable opportunity to recover the total costs of providing water services, and for the businesses to survive in the long term. At the same time, water businesses must be able to recover costs, so as to ensure that clean and reliable water services are provided in the long term. The water industry can enhance trust and reduce the adverse perceptions of rising prices by communicating transparent information to their stakeholders. This thesis assists in our understanding of the industry, possibly leading to increased market efficiency and the lowering of the cost of capital. On the one hand, the price of water must be high enough to provide the business (and its owners) with a fair and reasonable opportunity to recover the total costs of providing water services and for the business to survive in the long term. On the other hand, the price of water must remain at minimum levels to provide the business recovery of ongoing costs while consumers enjoy a dependable and reliable water service. 21

24 Research into economics-accounting issues affecting utility businesses is treated as unique due to the relevant operating and regulatory environments. Hughes et al. (2012, p. 49) argued that they are excluded from samples consisting of non-regulated, mainstream businesses that may possibly impose opportunity cost from excluding this sector of the economy. As such, this thesis is the first study undertaken in the area of asset valuation and the pricing of water utilities in Australia. The main objective of this research thesis is to investigate whether the price of water charged by water regulators in all Australian jurisdictions is indeed the correct price. It discusses how the price of water is calculated, and establishes a common understanding as to why the two main asset valuation techniques remain the recommended techniques in Australia. In the absence of a definitive economics-accounting framework and guidance, the aims of this thesis are to ensure that the accounting profession, academics and the regulators have a detailed theoretical understanding of the deprival value method. In particular, under the deprival value method, two main asset valuation techniques are used for price-setting purposes; that is, the depreciated optimised replacement cost (DORC) and economic value (EV) valuation models, in context of water utility pricing in major Australian jurisdictions. In doing so, some practical issues that arise in the implementation of asset valuation techniques can be resolved on a basis consistent with its underlying objectives. In making these objectives apparent, academics and practitioners will be able to judge whether deprival value principles are well suited to tariff regulation, and whether the financial models can be usefully transferred to other price-setting and financial modelling applications, in the public and private sectors. 1.7 Structure of thesis The structure of the thesis, including a diagram illustrating it (see Figure 1.1 below), is as follows. Chapter One Background information on Valuation of Assets and its Impact on Water Utility Pricing in Australia: The history, definitions and development of the valuation of water infrastructure assets is discussed, as well as some issues in relation to regulation of water utility assets pricing. The chapter includes a brief review of asset valuation 22

25 techniques used in other utilities, and a discussion of the methodology adopted for this research. Chapter Two Characteristics of Urban Water and Current Water Pricing Approaches: This chapter discusses the main characteristics of the industry, along with the regulatory approaches used by the states/territories and the NWI which binds them. The regulation of water prices exists to ensure safe and adequate provision of essential water services. Three aspects of economic efficiency allocative efficiency, dynamic efficiency and productive efficiency are therefore described. The method used to regulate water prices, the building block approach, is also described in this chapter. Chapter Three Literature Review: A general overview of the valuation of assets from an academic point of view is provided in this chapter. The chapter reiterates the fact that at present, academic research in relation to asset valuation and pricing of utilities, particularly water, is very limited. Chapter Four The Urban Water Industry in Major Australian Cities: This chapter provides an overview of water industry governance, structure and the broad area of ownership of urban water services in major Australian cities. Chapter Five Urban Water Regulation and Pricing: This chapter focuses on the history of water pricing and institutional reform. The differences in the coverage of economic regulation between Australian jurisdictions is examined in this chapter, followed by a discussion of existing pricing structures in the water and wastewater sectors in Australia s major capital cities. Chapter Six Asset Valuation Techniques Used in Water Utility Businesses: This chapter discusses a range of issues in relation to the valuation of water businesses assets. To begin with, some general issues are discussed, followed by a debate on the role of asset valuation in relation to regulatory control, and then a discussion of the deprival value and background information of the optimised deprival value. An overview of asset valuation techniques is also provided in this chapter. 23

26 Chapter Seven Asset Valuation Method Using the ODV: This chapter continues with the discussion on asset valuations. The deprival value is part of current cost accounting (CCA) standards in Australia, and an overview of the history and development of CCA is provided in this chapter. It also includes an examination of the steps involved in asset valuation method using the ODV. Chapter Eight Research Methodology: One of the most important decisions to be made in any research project is selecting the research methodology. A general overview of research methodology is discussed in this chapter, followed by an overview of the types of research methodology used in accounting research. The exploratory case study research methodology was used in this thesis, which draws on archival (secondary) data collection and quantitative (numerical) methodology. Figures of different asset valuation techniques are taken from electricity and gas companies random events. This approach is called simulation, a process that approximates those of the real-world results. The process of preparing and collecting data is presented, so that analysis of important issues can be finalised in the next chapter. Chapter Nine Results and Discussions: A summary of comparisons and findings of different asset valuations used by utility businesses is provided in this chapter. It discusses in detail why the deprival value stands as the recommended asset valuation method for charging purposes, and concludes by reviewing whether the current price of water is reasonable. Chapter Ten Summary and Conclusions: Summary, conclusions and lessons to be learnt are discussed here, and future research directions are also drawn out. The scope, assumptions and limitations of this research are also outlined in this final chapter. 24

27 Figure 1.1: Summary of thesis structure Chapter One Background information on the Valuation of Assets and its Impact on Water Utility Pricing in Australia Chapter Two Characteristics of Urban Water and Current Water Pricing Approaches Chapter Three Literature Review Chapter Four The Urban Water Industry in Major Australian Cities Chapter Five Urban Water Regulation and Pricing Chapter Six Asset Valuation Techniques Used in Water Utility Businesses Chapter Seven Asset Valuation Method Using the ODV Chapter Eight Research Methodology Chapter Nine Results and Discussions Chapter Ten Summary and Conclusions 25

28 Chapter Two: Characteristics of Urban Water and Current Water Pricing Approaches 2.1 Introduction In general terms, water satisfies people s thirst and is considered a public necessity. As an essential component of life, the urban water industry comprises of approximately 300 utilities in Australia, and most states are responsible for their own water policy decisions. These decisions are bound by their signatory obligations to the NWI, an agreement that was signed by all Australian states and territories at the 2004 meeting of the COAG. Its aims are to provide a long-term, national plan for water reform (Langford & Piccinin 2004, pp ; Engineers Australia 2010, p. 63). As most parts of Australia receive highly erratic rainfall, water supply requires considerable planning, which can be very challenging for the Australian Water Management. There are also infrastructure costs associated with the delivery or use of water, which has led to excessive use, over-investment in infrastructure, and environmental degradation in some areas. Furthermore, as discussed in Chapter One, there are no market-determined prices available to signal relative scarcity value of water. Since the water industry is a natural monopoly, competition is often not possible; hence it is important that the price of water is regulated to reflect its scarcity value. In line with this, this chapter discusses the meaning of such regulations, including their importance and the rationale behind them. It also reviews some common policy objectives for regulation of water prices, along with discussion on economic efficiency which is promoted not only when water prices reflect the opportunity cost of supplying water, but also when regulation is in place. Efficient prices need to be set so that efficient water usage and supply outcomes can encouraged. The price for water is not determined in a market that reflects demand and supply for water service, but is instead governed by a regulator based on a number of factors and stipulations. While it takes into consideration the burden for consumers, it must also provide appropriate signals to users with respect to the resources used and costs incurred 26

29 in the context of current and future availability of water, as well as environmental considerations, consumer needs and social policy objectives. Following this general discussion, the chapter will further refer to the actual specific approaches used in urban water pricing. Even though most regulators in Australia use the building block approach to regulate their urban water prices, there are other approaches such as price caps, weighted average or tariff baskets, and revenue caps which directly or indirectly control water providers charges. The approaches used vary depending on the incentives presented to the water industry, the allocation of risks associated with unexpected changes in water demand, the level of pricing flexibility, and the different pricing mechanisms dependent on water providers administrative complexity. Pricing principles for water are contained in the strategic framework for water, as explained in the Compendium of National Competition Policy Agreements, and the urban water services industry adopted the water resource policy by no later than Paragraph 6 of the COAG Water Resources Pricing Principles (NWI 2010, p. 18) states that economic regulators (or equivalent) determine the level of revenue for the water industry based on efficient resource pricing and business costs. Furthermore, paragraph 7 of the COAG Water Resources Pricing Principles (NWI 2010, p. 18) states that in determining the prices, transparency is required in regards to community service obligations, contributed assets, their opening value, externalities such as resource management costs, and tax equivalent regimes. With the combination of specific prices and revenue controls, this approach forms the basis of water prices in Australia. 2.2 Main characteristics of water As an essential component of all life, water has some characteristics distinct from any other goods. Some of its main characteristics are summarised in Diagram 2.1 below. 27

30 Economic good Public good Nonsubstitute (no alternative) Scarce in some places, plentiful in others Difficult & expensive to transport A special commodity Not freely tradeable Basic essential Characteristics of water Subject to regulation & price control Diagram 2.1: Main characteristics of water Water is the basic necessity that no life, human, animal or plant, can live without. Water is a special commodity which has an EV, as people are willing to pay for water rather than go without it. Water is a raw material that is used in the production of food and that satisfies people s thirst, and therefore qualifies as an economic good; that is, something intended to satisfy wants and needs of a consumer. Water is also a public good; no one can be denied access to water with the exception of the driest parts of the world, and there are no close substitutes or alternatives to it. It is plentiful in some places, such as the uninhabited mountain ash forests high up in the Yarra Ranges, east of Melbourne, but it is scarce in other areas such as the densely populated parts of south east Australia. Water, relative to its value, is difficult and expensive to transport against gravity. It is not only heavy, but unlike gas cannot be compressed. Water in lakes and rivers, for example, is not freely tradeable or dividable as a resource, and is therefore subject to government regulation and price control. A key implication of this is that water markets serving Australia s major cities are not and are unlikely ever to be as closely integrated as the electricity markets have become. This means that a one size fits all approach to urban 28

31 water markets is unlikely to succeed. Each market needs to be considered separately, particularly in regard to the supply of water (The Allen Consulting Group 2009, p. 7). 2.3 The urban water industry The year represented a positive change for the Australian urban water industry, as increased rainfall across eastern Australia (including South East Queensland and areas of New South Wales) led to a rapid rise in storage levels in many of Australia s catchments. Yet even though most water utilities were able to ease water restrictions or move to permanent water conservation measures, Perth continued to record low rainfall. The unexpected floods in early 2010 in Queensland highlight Australia s extreme climate variability and the ongoing water challenges (Australian Government 2011, p. 1). In relation to the approximately 300 water utilities, an estimated 70 per cent of Australia s population is serviced by 26 of them, while the 200 smaller utilities collectively serve only three million customers (Water Services Association of Australia 2004, p. 46; National Water Commission 2005, p. 31). In total, Australia s urban water industry services 20 million customers and the urban-based industries, manage 17 per cent of Australia s water use (Water Services Association of Australia 2004, p. 46). The Queensland Competition Authority (QCA) (2000, p. 11) suggested that before water can be provided to communities, there are costs (infrastructure designed to harvest, store, treat and deliver water) involved in its provision. Water as a resource has costs associated with diverting it from other users to meet the requirements of domestic, commercial and industrial users, or particular groups within these categories. While demand for water is determined by needs, preferences and practices of consumers and industries within a particular region, and the need to maintain sustainable environmental systems, its supply is governed by the hydrological cycle, the availability of groundwater, and the infrastructure to harvest and distribute it to consumers and users. The Allen Consulting Group (2009, p. 5) explained that the urban water supply and wastewater management consists broadly of functions ranging from water harvesting and storage, through to provision of drainage and the management of sewerage (refer to Figure 2.1 and Table 2.1). 29

32 Figure 2.1: Urban water supplies Urban water supplies Supply sources, e.g. desalination and recycling Treatment, e.g. treatment plants Distribution, e.g. reservoirs Retail, e.g. grey water and sewerage Waste, e.g. treatment and distribution Environmental use Stormwater Drainage Ocean Potential convert wastewater back to water supply (The Allen Consulting Group 2009, p. 5) Table 2.1: Key water functions Functions Supply, harvesting and storage Treatment Distribution Retail Wastewater Drainage Components Water storage and harvesting, including catchments, dams, aquifers, desalination, recycling and stormwater collection Treatment of water to meet appropriate standards Water transport, system operation and management of temporary storage (reservoirs) Billing services, marketing, customer management Sewerage transportation, wastewater treatment and disposal Collection and transportation of stormwater (The Allen Consulting Group 2009, p. 5) 30

33 The two main services provided by the urban water industry are the supply of reticulated, potable water, and the collection, treatment and disposal of wastewater (Australia Government 2011, p. 3). The physical and economic characteristics of urban water are common to those of other reformed utility industries, such as gas and electricity. For instance, the two key features of water particularly relevant to the Australian urban management are that the rain-fed supply of water is uncertain, and that while water is in dams and reservoirs, it is relatively cheap to store (The Allen Consulting Group 2009, pp. 6 7). The essential nature of water services raises important questions: How much of a supply buffer should be maintained as insurance against extensive drought? How much future growth is required so that supply can cater for demand? Maintaining surplus capacity is not only expensive, but also limits the ability to adapt to changing seasonal and demand conditions. The size of a supply buffer involves a tradeoff between a consumer s willingness to pay for reliability and the cost of constructing and maintaining surplus capacity. The issue of planning for uncertain water supply is particularly challenging for Australian Water Management, as most parts of Australia s urban water supplies are dependent on highly erratic rainfall. As recent history demonstrates, much of the Australian continent is subject to periodic droughts that can be severe and extended, and this creates a problem in determining the reserve supply that needs to be stored for future consumption. A solution to this problem is to produce water via alternative processes such as desalination, recycling sewage, and collecting and treating stormwater for reuse. However, the cost of desalination and recycling can be prohibitively high compared with existing sources (The Allen Consulting Group 2009, pp. 6 7). 2.4 What is a regulation? A regulation is defined in the Oxford Dictionary as a prescribed rule or authoritative direction. The Macquarie Dictionary defines it as a rule of order, as for conduct, 31

34 prescribed by authority; a governing direction or law. The Department of Treasury and Finance (2007, p. 3) described it as rules (e.g. primary and subordinate legislation and codes of practice) set by government, either through legislation or similar instruments in order to set standards for appropriate behaviour in the public s interest. Traditionally, regulations exist to ensure safe and adequate provision of essential public services, such as energy, water and transport. Fundamentally, they exist to protect customers, the community and the natural environment. Water being a natural monopoly calls for regulation. In the water industry, economies of scale are large in relation to the size of the water market, where capital costs are typically per cent of the total cost and it is probably expensive to build or duplicate water pipelines. The monopolist s market is therefore unlikely to be entered by a potential competitor, as this would involve a considerable amount of capital investment. Rather, it is cheaper if one infrastructure is used with its price-setting controlled. It is wasteful to duplicate the entire infrastructure and would also cost the community a considerable amount of money. Thus in the water industry, regulation can be viewed as a substitute for competition where competition is either lacking or not possible (SAHA International Limited 2007, p. 8; Pardina, Rapti & Groom 2008, p. 1; Abbott & Cohen 2009, p. 233). In this market environment, water regulation intervenes for consumer welfare at a number of levels; one of the most important is that without it, the power of the providers would be such that they could set prices at a level that delivers more than a normal commercial return. Further, the lack of choice for consumers to change providers leads to the providers being able to offer a potentially substandard level of service without the risk of losing a consumer. Regulation also intervenes in respect to the environment, as there are potential unwanted side effects from water service provision, such as damage to the environment or risking public health. Some form of government intervention is also appropriate for maintaining minimum health standards for particular customer groups, such as low-income families, to ensure that they are treated equitably. 32

35 In South Australia, Queensland, Tasmania and Western Australia, regulatory agencies conduct reviews on matters referred to them by the government, including water pricing. These regulatory agencies advise government on pricing as opposed to regulating prices (reviewing pricing policies), as they do in other states and territories including Victoria, New South Wales and the Australian Capital Territory (Economic Regulation Authority 2007, p. 4). Research in accounting regulation draws on a variety of explanatory theories, such as public interest theory (Posner 1974, pp ), private or economic interest theory (Deegan, Morris & Stokes 1990, pp ), institutional theory (Powell & Steinberg 2006), political economic theory (Puxty et al. 1987, pp ) and capture theory (Walker 1987, pp ). In particular, capture theory regulation is a theory associated with both Richard Posner, an American economist and lawyer and George Stigler, an American economist. Capture theory regulation is applicable to regulated industries such as water utilities. The industry may benefit from the process via direct subsidies of money, entry control, price fixing, or control over substitutes or complements. Regulatory industries such as water, railway and electricity utilities submit to certain rules, regulations, standards of conduct, or other interferences. Stigler (1971, pp. 3-21) argued that in doing so, there are costs involved and the net return to the regulated industry is higher (on average) than non-regulated industries. As long as the net benefit is positive and lobbying costs are not prohibitive, those who stand to gain from the regulatory process will demand it. 2.5 Why is regulation important? In Australia, the current regulatory frameworks for the water industry are based on a combination of legislative, regulatory instruments and decision-making bodies. The first system for regulation of the water industry was developed under the umbrella of the Trade Practices Act 1974, since replaced by the Competition and Consumer Act While the Act deals with all aspects of water in the marketplace, including relationships among suppliers, wholesalers, retailers and customers, it also covers regulation of water industry. Following this, in 1994, through the COAG, the NWI was built. However, in many aspects, regulation of the water industry is still new and developing. 33

36 The regulation of utilities including water has been implemented in most countries by constraining the rate of return on capital. It seems that this is a necessity to attract capital to utilities while avoiding excessive exercise of monopoly power. Some main characteristics of this type of regulation, as asserted by Laffont (1994, pp ), are: A fair rate of return on investment above the market rate is guaranteed as long as investments are prudent. Prices are determined to equal average costs with imputed charge for capital. Prices remain fixed during the regulatory period, until a new regulatory review leading to new prices comes about. The regulatory review is a process of checks and balances in which the conflicts between the firm which demands high prices and the consumers who demand low prices are arbitrated by the regulatory commission. If left unregulated, water providers cannot be relied upon to deliver services where it should be valued by the community. That is, a business operating with purely commercial objectives will not operate to provide services unless it can make a profit. The business is likely to establish infrastructure where it can maximise profits, and may neglect other areas where smaller or no profits are available (Department of Treasury and Finance 2007, p. 5; SAHA International Limited 2007, p. 8). Regulation sets directions and ensures that service providers deliver services to all their customers. The regulatory regime provides certainty and protection to all stakeholders by implementing adequate penalties and incentives to promote desirable behaviours. It also ensures a better understanding of the expectations of the government and customers to support long-term business planning and decision-making. Long-term investments of service providers are also protected, and prices can be recovered from efficient operational and infrastructure costs (SAHA International Limited 2007, p. 8). The National Competition Policy (NCP) requires of all Australian states and territories that where legislation exists that restricts competition through licensing operators, they must be able to justify it as being in the public s interest (Department of Treasury and Finance 2007, p. 3). 34

37 2.6 Rationale for regulation In order to supply water services, significant infrastructure is required to store, treat and deliver water; however, it is not easy for a non-competitive market to establish these facilities. The Economic Regulation Authority (ERA) (2005, pp ) has explained that regulation of water prices commonly seeks to achieve multiple policy objectives, including the following: To signal the scarcity value of water that may arise because of infrastructure constraints or limited hydrological capacity. To control the revenue requirements of water businesses, so as to avoid passing on monopoly pricing of services to customers. To enhance the efficiency of service delivery without the absence of a competitive market. The rationale of water regulation should allow water providers to recover their cost of service delivery and earn a commercial rate of return on capital, at the same time promoting efficient service delivery. To manage demand through tariff structure adjustments. Price is one tool for managing the supply-demand balance. To reflect the net cost of environmental externalities. Its aim is either to recover costs associated with meeting environmental standards, or to send a price signal to water users to allow them to modify their consumption habits in order to avoid future environmental costs. To set tariff structures in order to meet social objectives in relation to the equitable distribution of costs to different customer groups. To encourage efficient outcomes that involve lowest possible costs to society. To encourage outcomes that are judged as fair. To use pricing rules that are simple, transparent and avoid excessive regulatory burdens. These objectives often involve trade-offs; for example, it is not possible to implement prices that optimise economic efficiency while also meeting equity and fair pricing criteria. Pricing structures must be developed to take into consideration administrative 35

38 practicalities and cost, revenue stability for water providers, price stability for the customer, customer acceptability, and transparency. Under normal market conditions, resources that are capable of being traded attract a scarcity that reflects users willingness to pay. However, this is not the case with water and regulatory prices, which must be used to reflect those scarcity values. The rationale is that if scarcity prices are revealed and resources efficiently allocated, this will maximise the sum of benefits from water by all users. However, there are efficiency problems related to water provision, because the characteristic of water is distinct from the resource itself (Johnstone 2003, p. 1; Vinnari 2006, p. 159; Department of Treasury and Finance 2007, p. 5; Fearon 2006, pp. 4 5; Sibly & Tooth 2008, p. 220; Economic Regulation Authority 2008, p. 10). 2.7 How to regulate A trend in regulation is to delegate the decision about structure of prices to the regulated entity, and to provide incentives for the entity to set efficient prices. In the water industry, within a regulatory period, the specific form of control over prices affects the pay-offs that may be associated with tariff rebalancing. It is a mechanism where the incentive to set efficient prices can be provided (The Allen Consulting Group 2003, p. 18). There are many forms of economic regulation. Fearon (2006, p. 5) suggested that it can be either characterised as light or heavy handed, and is generally applicable to sectors or businesses that exist along a continuum from pure natural monopoly to competitive markets. For example, in Victoria the ESC approach to regulation included regulation of natural monopoly networks under various forms of price-cap regulation, and regulating those industries experiencing some emerging competition, such as rail access, ports and grain handling, with some retaining power. 2.8 Economic efficiency and principles of efficient prices Regulation attempts to create prices that promote economic efficiency. Economic efficiency is: 36

39 A state of affairs in which, given the values of resources utilised, one has taken advantage of every available opportunity to increase the economic welfare of consumers through the provision of larger quantities of outputs, better products, or a mixture of outputs better adapted to consumer preferences (Kahn 1992, cited in Farrier Swier Consulting 2002, p. 20). Economic efficiency should provide incentive for consumers to use water efficiently, which can be enhanced through regulatory mechanisms. Water prices can be kept at a minimum level compatible with long-run sustainability of the service when economic efficiency is achieved, which can be categorised into three aspects: allocative efficiency, dynamic efficiency and productive efficiency. In any economy, prices reflect the opportunity cost of the available resources, and allocative efficiency ensures that resources are allocated to their most productive use through production and consumption decisions. Allocative efficiency is maximised where resources are allocated such that the value in use of the product is equal to the increment in the cost of supplying the product, at the very least. Dynamic efficiency ensures efficient investment decisions in the long term through the correct combination of options and right timing. In the water industry, dynamic efficiency refers to the ability of water businesses to improve the quality and cost of water and services, and to respond to emerging market developments. It relates to processes of both technological and managerial innovations, such as capital investments, research and product innovation. Productive efficiency focuses on producing at the minimum possible cost, given the available technology and input prices. Both allocative and dynamic efficiencies are also relevant issues given that the existing assets of the businesses are sunk costs. Productive efficiency is maximised where the regulated business treats prices as it would in a fully competitive market, and where existence of a number of distinct water service businesses makes it possible to compare the efficiency among them. In doing so, it induces competitive behaviour. Efficient investment in water network assets is a significant part of productive efficiency. It is critically important that correct decisions are made for investments, as this involves longterm decisions that may extend over regulatory periods for setting price caps. 37

40 Economic efficiency is reflected in NWI Pricing Principles, and promoted through efficient and sustainable use of water resources, water infrastructure assets and government resources devoted to management of water. The NWI is a shared commitment by governments to increase the efficiency of Australia s water use (NWI 2010, p. 2). By doing so, it leads to greater certainty for investment and productivity, not only for rural and urban communities, but also for the environment. The neo-classical approach to economics claims that equilibrium prices will just equal costs, including an allowance for return on capital. Even though natural monopoly represents a type of market failure, regulation can potentially solve these market failure problems. Regulation attempts to set prices just equal to cost and to replicate the outcomes of perfect competition. It is when the returns on capital are just sufficient to attract capital investment that allocative efficiency is achieved. Economic theory of market failure suggests that a private monopoly will abuse its market power in order to achieve profits in excess of those which would be available in a competitive environment. However, in contrast with this theory, Baumol and Willig (1986, pp ) set out the principles for efficient prices. These principles suggested that as long as the market is contestable, monopoly power will not be abused. Baumol and Willig explained what was required to ensure efficiency in presence of economies of scale or scope. The two principles they proposed have been widely adopted in Australia for instituting monopoly infrastructure services, particularly for intellectual justification of the DORC approach to asset valuation. They are designed to mimic the constraints placed on firms by contestable markets, and state that: No price, or set of prices, should exceed the stand-alone costs of providing service or services, where stand-alone costs are determined as the costs that an efficient competitor would incur in providing just that service or group of services. No price, or set of prices, should be less than the incremental (or avoidable) costs of providing the service or services, where incremental costs are additional costs incurred by the monopolist in providing just that service or group of services. 38

41 The two principles accord with upper-bound and lower-bound pricing principles developed by the NWI and its pricing working group (ACIL Tasman Economic Policy Strategy 2006, p. 2; ACIL Tasman 2008, p. 3). These two pricing principles will be discussed in detail in Chapter Nine. 2.9 Approaches to urban water pricing Efficiency is promoted when prices reflect the opportunity cost of supplying a particular good or product. For instance, the opportunity cost of consuming a unit of water is the value of supplying that water to another customer, or storing that water for future consumption to reduce the likelihood of future water shortages, given the inherent uncertainty with climate-dependent water supply sources. Opportunity cost is often the marginal cost of the resources required to provide another unit, such as a kilolitre (kl) or a GL of water to consumers. The National Water Commission (2008, pp. 6 7) broadly proposed economic efficiency as achievable where scarce resources, in this case water and assets involved in production, distribution and use of water, are allocated to uses that consume most at the highest value. In economic theory, consumption and production decisions in a particular market will be consistent with efficiency where the price of a good or service equals its marginal cost. That is, the price falls below marginal cost, demand from users will be far greater on the system, and this will result in resources being diverted to provide these services rather than providing a more valuable service elsewhere in the economy. If prices are more than marginal costs, consumers will not use enough water and the associated infrastructure services, which will result in a social welfare loss. Efficient prices therefore need to be set, as it is crucial to encourage efficient water use and water supply outcomes. For this purpose, the National Water Commission (2008, pp. 6 7) recommended that for efficient decision-making, it is crucial that the marginal cost or price reflects the full cost to society from providing a good or service, including any externalities. Externalities are costs or benefits which arise from an individual s economic activity that affect others, such as environmental impacts. To date, externalities are not yet reflected in water delivery prices, even though a key goal of the NWI is to ensure that prices reflect externalities. 39

42 Other than to ensure an efficient allocation of resources, prices play an important role in signalling the requirement for, and the value of, new investment. When supply demand balance tightens, the marginal cost of meeting demand also increases. This increase in marginal cost of supply provides important information about the type and timing of any new investment that is required. One of the ways typically used to address the issue of revenue adequacy while maintaining the efficient signals associated with marginal-cost pricing is the use of a two-part tariff, which consists of a variable charge and a fixed charge. The variable charge facilitates cost-reflective pricing and enables the costs associated with water usage to be signalled to customers, who can then adjust their consumption accordingly. In contrast, fixed charge ensures revenue adequacy, and reduces variability of revenue to the water business. The structure of the variable component of water charges for residential customers in Australia is known as inclining block tariffs, whereby the price of water increases as its consumption increases. It is comprised of one or more blocks or tiers (up to 11). The National Water Commission (2010, p. 17) noted that one block tariff is used by Sydney Water, while 11 blocks tariffs is practised by Albany and Kalgoorie-Boulder Water Corporation in Western Australia. The only jurisdiction which allows more than three inclining blocks is Western Australia. All major Australian cities with the exception of Newcastle, Gold Coast and Darwin have incorporated inclining block tariffs into variable components of tariffs. Some would argue that inclining block tariffs can send a strong signal about the need to conserve water to high-volume users. However, a large family may engage in water conservation to achieve reduction in demand but not be rewarded for their effort The current urban water pricing approach The price for water cannot be determined in a market that reflects demand and supply for water service, where the regulator assesses the price for water proposed by water utility business, taking into consideration two aspects. Firstly, the water price paid in total by customers, and the total revenue the water businesses derive from the price of water must reflect the reasonable costs incurred by the water utility businesses, including a rate of return on the RAB. Secondly, the structure of the water price must provide appropriate 40

43 signals to users of water in respect to the resources used and costs incurred in provision of services, in the context of current and future availability of water, environmental considerations, customer needs, and social policy objectives (Economic Regulation Authority 2004, p. 3). The National Water Commission (2008, p. 8) acknowledged that in general, the current approach to urban water pricing varies across Australian jurisdictions. The Steering Group was established in 1990 to develop a consistent approach to pricing and has identified four areas of inconsistency of approach between jurisdictions. These inconsistencies are: recovery of capital expenditure setting of urban water tariffs recovery of costs of water planning and management recycled water and stormwater use. The IPART in New South Wales and the Australian Capital Territory, and the ESC in Victoria govern pricing regulation. It is also the ESC in South Australia, while the QCA performs that role in Queensland. Tasmania relies on the Pricing and Oversight Commission, while Western Australia s pricing regulator is the ERA. While it was noted that not all jurisdictions adopt all of the same elements, there are some similarities between them. For instance, water regulators use the building blocks methodology, where an annual operational expenditure and a rate of return on and of an RAB are used to determine a revenue requirement to be recovered from customers. The building blocks equation is described in various literature, such as the NWI Steering Group on Water Charges (2007, p. 14), cited in the NWI Pricing Principles (2009, pp. 5 & 164), ERA (2004, p. 3), Balance and Taylor (2005, p. 37) and Nera Economic Consulting (2014, pp. 5-6) as follows: Revenue requirement = Benchmark operating expenditure (including operations, maintenance, administration costs) + 41

44 Return on capital (RAB) + Return of capital (D) or depreciation. Expressed in the simplest form, the building block equation is as follows. Figure 2.2: The building block equation Return on capital (WACC * RAB) Return of capital (D) OPEX MAR MAR = maximum allowable revenue WACC = weighted average cost of capital (post-tax nominal) RAB = regulatory asset base D = depreciation OPEX = operating and maintenance expenditure In Australia, most regulators use the building block approach to regulate urban water prices. An annual forecast revenue requirement is calculated, based on estimates of funds the business requires to efficiently deliver its services and to meet its regulatory and other obligations. Klein (1996, p. 16), Johnstone (2003, p. 2) and Balance (2006, pp ) all identified the building block approach as including such things as the operating cost, such as what the pipelines company pays for managing the water system. This example may include workers wages, the cost of constructing new pipelines, water plants suitably depreciated, 42

45 depreciation or maintenance of existing investments, and cost of capital. Some common characteristics of the building block approach are as follows: The use of periodically reviewed price caps, where a fixed duration of the determination is used (usually between three and five years) to recover the revenue requirement. The use of a two-part tariff (comprising a fixed, service availability charge and a variable volumetric charge). The use of inclining block tariffs in the variable component of charge, where this charge is set to two or more usage blocks, with increasing prices as consumption increases. Inclining block tariffs are used in all major Australian cities, with the exception of Newcastle, Gold Coast and Darwin. The use of postage stamp pricing, where uniform prices are charged to customers in different geographical regions or across different customer types. The use of developer charges, where developers pay up-front charges to utility companies for the infrastructure costs incurred in servicing new developments The current water pricing arrangements The National Water Commission (2008, p. vii; 2011, pp. 7 8) acknowledged that the pricing arrangements vary between jurisdictions, but are typified by a regulated approach based on the building blocks methodology with periodic price reviews. The most commonly used is the two-part inclining tariff, which consists of a volumetric (variable) and a fixed component. The volumetric (variable) component is set with regard to the long-run marginal cost of additional supply capacity, while the fixed component is set to ensure revenue adequacy. The volumetric (variable) charge is used where this charge increases in blocks with the quantity consumed. The more a customer uses water, the higher the volumetric charge is. The volumetric (variable) component has a stronger impact on water use decisions and is particularly important when water is scarce. In times of water shortages, restrictions are enforced to manage demand, and the current approach to urban water pricing encourages 43

46 technical efficiency and protects against the practice of market power (Sibly & Tooth 2007, p. 5). Every state and territory in Australia, with the exception of Western Australia and South Australia, has converted from property-based charges to volume-based. Sydney Water, ACTEW Corporation, NT Power, Water Authority and Brisbane Water have adopted a standard flat charge. The four Melbourne retail water companies and Hunter Water in Western Australia have adopted a two-part tariff comprising a service charge and a usage charge, based on estimated discharge. Sydney Water, ACTEW Corporation and Brisbane Water have all adopted a fixed service charge. With the exception from Hobart, all Australian capital cities and many regional urban areas adopted two-part tariffs for potable water supply. This is largely to allow jurisdictions to meet NWI commitments. Water meters with a variable and fixed service component are used. This replaced property values and free allowances as the basis of water charges. The National Water Initiative (2011, p. 80) reported that since 2009, Tasmania has been rolling out water meters to all remaining unmetered urban areas, particularly in southern Tasmania. From July 2012, two-part pricing based on consumption was adopted across Tasmania. In 2002, the IPART found that a two-part tariff was not warranted for cost-reflective reasons, due to the high proportion of fixed costs and inelastic internal demands. The South Australia Water Corporation has adopted a minimum charge, together with a rate based on property value, where the unimproved value exceeds a certain minimum limit (Government of Western Australia, Department of Treasury and Finance 2005, pp ). In most water jurisdictions in Australia, it is the independent pricing regulators who are left with the task of actually determining the price, and/or at least setting the principles that might be applied in making a decision on what the price should be for water. Those prices that the regulator naturally considers in some detail are costs that are incurred in this process (including the capital investment costs). This will form a view as to whether the expenditure involved is efficient and prudent, and will then establish an appropriate 44

47 form of regulation that will allow the recovery of these costs in revenues collected by the utility over the regulatory period. Some of the issues that are considered by the regulators include the following: need for capital investment being proposed extent of any efficiency savings that have been made how these savings should appropriately be shared between water utility and customers the likely level of demand over the relevant regulatory period. Taking into consideration some of these issues, assumptions can be made regarding recovery of costs through prices that are set, and appropriate amortisation and handling of costs whether they are capital equipment costs or investments in skills and expertise that will have benefits that extent beyond the regulatory period. As Australia recently experienced a period of unprecedented drought, it is obvious that water utilities do not have the ability to determine whether it will rain, or to predict a possible significant shift in Australia s rainfall patterns going forward (Independent Competition and Regulatory Commission 2008, p. 13; Rowe 2008, p. 3). Regulators of water utilities must therefore take every reasonable step to ensure that reliable water supplies are available for urban areas, and that there is a financial incentive to deliver on these water requirements. Enforceable service standards must apply for such things as the repair of broken water mains, the quality of the water delivered and the reliability of supplies Background of regulatory models Some form of regulatory price control is required to promote efficiency in the urban water industry and to achieve social and environmental goals. For some water services, it may be sufficient for the regulator to allow the service provider to propose prices that comply with a number of regulatory principles, rather than prescribe specific tariffs or weighted caps (price and revenue caps). For instance, in Victoria the ESC has considered such an approach for services that are required by a small number of specific classes of 45

48 customers, such as developers, commercial firms discharging trade waste, and users of recycled water (Economic Regulation Authority 2005, p. 150). There are a number of options available to control the prices, directly or indirectly, that water providers charge for their services. These approaches vary depending on the incentives presented to water providers, allocation of risks associated with unexpected changes in water demand, level of pricing flexibility they can afford, and different pricing mechanisms used depending on water providers administrative complexity (Economic Regulation Authority 2005, p. 150) Price and revenue caps individual price caps Water businesses are permitted to set a rate of return on their capital. As can be observed in Figure 2.2, this rate of return is the RAB used in the calculation of MAR. Price-cap regulation is a form of regulation in which utilities companies are permitted to place a price cap on the price of services they charge based on a return on capital. In price-cap regulation, the price of water is the regulated variable. Price-cap regulation when implemented can hold down prices for services that are not subjected to competition (Organisation for Economic Cooperation and Development 1995, p. 5). In 1984, British Telecom in the United Kingdom implemented prices for these services that were typically close to their maximum price cap permitted levels, when regulation based on incentives such as price and revenue caps were first introduced. In price-cap regulation, the CPI-X system sets revenue caps. The Consumer Price Index (CPI) is the rate of inflation measured by CPI, and subtracts the expected efficiency savings; X. The price caps regulation first began in the United States telecommunications industry in the mid-1980s, and by 2000 thirty-nine states in the United States had employed pure price caps regulation. Sappington et al (2001, pp ) reported that the first price-cap regulation was introduced in 1992 for the United States telecommunications markets, when the telecommunications markets became increasingly competitive because of technological changes. 46

49 In Australia, the price-cap regulation was first used by Telecom in 1989, with a CPI -4 per cent formula. The scheme was applied to regulatory periods of three years between July 1989 and June However, it was not until recently, within the last 10 to 15 years or so, that price caps have been applied more widely to other sectors, such as those of long-term natural monopolies including the electricity and gas distribution, and water utility networks. The price cap is the most common method used in regulated utility businesses. It is made up of the sum of operations, maintenance, administration, and depreciation costs. For this reason, the price cap is known as the building block price-setting (Queensland Competition Authority 1999, p. 8). The price cap is typically applied in the context of access pricing when setting arbitrated prices for access to individual pieces of infrastructure in a network. Prices are either approved by the regulator or government at the start of a defined regulatory period, or escalated annually in line with inflation. The water provider must adhere to the approved prices, and no adjustments are allowed within the regulatory period. The volume of water sold becomes a key driver of total business revenues (Economic Regulation Authority 2005, pp ). The price cap approach is prescriptive in those specific services that are set for the term of the regulatory period, with explicit efficiency factors built into the price path. The advantage of using this approach is that it provides price-certainty for the water business, and a strong incentive to improve efficiency. However, the provider is unlikely to make price adjustments in response to changes in its operating costs, or changes in demand for its services over the regulatory period. Price caps are similar to a revenue cap in that the price cap may be applied to particular customers or services, but is established on a unit basis, such as per KL or ML, rather than as a total revenue amount. The two state regulators currently using the price cap approach to regulate water providers are the IPART of New South Wales and the Victorian ESC, both of which have capped their prices for , with a view of using a tariff basket in future years. Pricecap regulation has been adopted extensively in Water Services Regulation Authority (OFWAT), in England and Wales (Queensland Competition Authority 1999, p. 9). 47

50 Weighted average price cap (or tariff basket) The approach to price control limits price increases on the basis of a weighted average of the prices of a basket of services. The weights are usually based on the actual quantity of service sold, and is fixed with reference to a base year. On the condition that the weighted average increase in prices is within the overall cap, the provider is able to adjust prices (known as rebalancing ) within the basket, and the cap is escalated in line with inflation and an efficiency factor (e.g. CPI-X). To date, tariff baskets are used to regulate electricity and gas businesses, and have not been applied to water businesses (Economic Regulation Authority 2005, pp ). Weighted average revenue cap Instead of prices being regulated, the weighted average revenue cap approach of control limits the water provider s average revenue per ML of water sold. Prices can be rebalanced, as long as the adjustment does not exceed the average revenue cap. The cap is set on the basis of a benchmark revenue requirement set by the regulator, together with a demand forecast. Weighted average revenue cap indirectly controls the price by placing a cap on average revenue per ML of water sold. This allows the water provider some flexibility to adjust the prices and quantities of different services supplied. A disadvantage of greater pricing flexibility is higher price volatility for customers. However, this approach to price control does not restrict the water provider from expanding its customer base. One state which has recently opted for a weighted average revenue cap to regulate water prices is the Independent Competition and Regulatory Commission (ICRC) in the Australian Capital Territory (Economic Regulation Authority 2005, p. 152). Revenue cap The revenue cap is another indirect method to control the prices. With this form of control, the maximum revenue that can be earned by the water provider is set at the 48

51 commencement of a regulatory period, and it is up to the water provider to adjust prices, quantity or costs, as long as revenue does not exceed the stipulated cap. This approach provides water businesses with an incentive to improve efficiency; however, it is a disincentive to sell more water (Economic Regulation Authority 2005, p. 152). The revenue cap is also a potential useful tool for achieving conservation targets. However, this form of control has been known to be problematic, because the water provider is exposed to the risk of unexpected increases in demand, and in such cases must be able to meet new demands by either lowering the cost or the price below its revenue requirements to remain within the cap (Economic Regulation Authority 2005, p. 152). On the other hand, when demand is lower than expected, such as due to enforced water restrictions, the water provider has an incentive to increase prices, which could impose additional costs on consumers. Higher prices imply a less reliable service. IPART of New South Wales, for example, generally constructs a maximum revenue target for the business, comprising a return on capital, return of capital and operating costs, and then sets specific price paths for water services consistent with this constraint. This became the base for price caps for Western Australia s Hunter Water and the Sydney Water Corporation. The IPART has also used a form of revenue cap for regulation of water services provided by Gosford and Wyong City Councils. However, these entities are concerned that revenue cap regulation provides less flexibility to manage climateinduced demand variability (Queensland Competition Authority 2000, p. 27). 49

52 2.14 Summary As established earlier, water is the most precious natural resource, and it is difficult for any living being to survive without it; thereby categorising it as an economic good. In Australia, it is plentiful in some places such as the uninhabited mountain ash forests high up in the Yarra Ranges, East of Melbourne, but scarce in other areas such as the densely populated areas in south east Australia. Australia is, on a per capita basis, one of the highest consumers of water in the world, with each Australian using 1.31 million litres of water per year. On an average, this was a total of GL as at enough water to fill the Sydney Harbour 48 times (one GL is litres). The year represented a positive change for the Australian urban water industry, with an increased rainfall across eastern Australia (including South East Queensland and areas of New South Wales), which led to a rapid rise in storage levels in many of Australia s catchments. Most water utilities were able to ease water restrictions or move to permanent water conservation measures, except in Perth which continued to record low rainfall. The recent unexpected floods in early 2010 in Queensland highlight Australia s extreme climate variability and the ongoing water challenges. The urban water industry consists of the provision of two main services: the supply of reticulated potable water, and the collection, treatment and disposal of wastewater. Even though most states and territories are responsible for their own decisions about water policy, these decisions are bound by the fact that they are signatory to the NWI, an agreement signed by all Australian states and territories at the 2004 meeting of the COAG. Traditionally, regulations exist to ensure safe and adequate provision of essential public services, including water. Fundamentally, they exist to protect customers, the community and the natural environment. 50

53 The natural characteristic of water as a natural monopoly calls for regulation. Without regulation and a lack of competition in the water industry, it means that the providers yield a level of power where they could price at a level that delivers more than a normal commercial return. Also, the lack of choice for customers to change providers leads to the providers being able to offer a potentially substandard level of service without the risk of customer loss. Regulation is particularly important in South Australia, Queensland, Tasmania and Western Australia, because regulatory agencies carry out reviews on matters referred to them by the government, which includes water pricing. These regulatory agencies advise the government on pricing, as opposed to regulating prices as in other states and territories such as Victoria, New South Wales and the Australian Capital Territory. In Australia, the current regulatory frameworks for the water industry are based on a combination of legislation, regulatory instruments and decision-making bodies. The first system for regulation of the water industry was developed under the umbrella of Trade Practices Act 1974, now known as the Competition and Consumer Act In 1994 through the COAG, the NWI was established, which means that in many aspects regulation of the water industry is still new and developing. Regulation is the public economics face of industrial organisation. Regulations allow governments to not only explore in various ways, but also interfere with industrial activities. Under complete information, technological efficiency requires a single operating firm; most importantly, the framework of the new economics of regulation can be viewed as an application of principal-agent methodology. This is based on contractual relationship set-up, in which the principal is the state or the regulatory institution, and the agent is the regulated firm (i.e. water business). The regulation of utilities has been implemented in most countries by constraining the rate of return on capital, which is a necessity to attract capital to utilities while avoiding excessive exercise of monopoly power. Some main characteristics of this type of regulation are that a fair rate of return on investment above the market rate is guaranteed, as long as investments are prudent, prices are determined to equal average costs with the imputed charge for capital, prices remain fixed during the regulatory period until a new 51

54 regulatory review leading to new prices is released, and the regulatory review is a process of checks and balances where the conflicts between the firm demands high prices and the consumers who demand low prices are arbitrated by the regulatory commission. Without regulation and lack of competition, service utility providers cannot be relied upon to deliver services where they are most needed and valued by the community. A business operating based on its commercial objectives will not function to provide services unless it can make a profit. Such a business is likely to establish infrastructure where it can maximise profits, and may neglect other areas where smaller or no profits are available. Regulation can therefore set direction and ensure that service providers deliver services to all their customers. Regulation attempts to create prices that promote economic efficiency. The three aspects of economic efficiency allocative efficiency, dynamic efficiency and productive efficiency have previously been discussed. A regulated approach based on the building blocks methodology with periodic price reviews typifies the current pricing arrangements, although they vary between jurisdictions. The most commonly used approach is the two-part, inclining block tariff, which consists of a fixed and volumetric (variable) component. In Australia, almost all properties are connected to reticulated systems, which allow water to be metered. A water bill incorporates a separate fixed charge and usage (variable) charge. The fixed component is set to ensure revenue adequacy, and the volumetric (variable) component is set with regard to the long-run marginal cost of additional supply capacity. Every state and territory in Australia, with the exception of Western Australia and South Australia, has shifted from property-based charges to volume-based ones. Sydney Water, ACTEW Corporation, NT Power, Water Authority and Brisbane Water have all adopted a standard flat charge. The four Melbourne retail water companies and Hunter Water in Western Australia have adopted a two-part tariff comprising of a service charge and a usage charge, based on estimated discharge. In the water industry, the regulation of prices relies on the building block approach, whereby the components of total costs of providing the services are assessed to determine 52

55 the revenue requirement of the service provider for a predetermined period. Based on the forecasts, prices are then derived so that they will deliver this revenue. Water businesses use a number of options such as price caps, weighted averages, or tariff baskets and revenue caps to control the price of water. The price cap is the most common method used, also known as the building block price-setting, and is a result of the sum of operations, maintenance, administration and depreciation costs. The price of water is the regulated variable in price-cap regulation. The next chapter is the literature review, providing a general overview of valuation of assets from an academic point of view. 53

56 Chapter Three: Literature Review 3.1 Introduction Chapter Two outlined the main characteristics of water and the methods used to regulate water prices; that is, the building block approach. It also discussed the characteristics of the urban water industry and the current water pricing approach in major Australian cities. The current approach to urban water pricing varies across Australian jurisdictions. Water regulators use the building block approach, where periodic price reviews are conducted and an annual operational expenditure and a rate of return on and of an RAB are used to determine revenue requirements to be recovered from customers. Chapter Three provides a general overview of asset valuation from an academic point of view. Very little academic research has been published on this topic, particularly in relation to the deprival value methodology, which is used to determine water pricing. Later chapters will provide an extensive literature of asset valuation based on research published in industry reports. Past research in relation to asset valuation techniques has concluded that the sensitivity of asset valuation is not only on the RAB, but also potentially on price levels. The building block approach is used to calculate the MAR for the regulated water business, where the regulatory period is typically between three and five years. Total revenue is forecast for this predetermined period, and the price of water is derived on the basis of demand forecasts, which are expected to deliver from forecasted revenue. The asset valuation method has made a significant impact on profit; the excess of income over expenses can be compared over time and between various water utility businesses. A central role of accounting theory is to provide prescription and to inform others about the optimal accounting approach to be adopted and why particular approaches to accounting are considered optimal. Based on this perspective of the role of accounting, normative accounting theory prescribes that assets should be valued using specific asset valuation techniques. This chapter therefore considers normative theories in discussing and describing asset valuation techniques used in utility businesses. 54

57 The first discussion in this chapter is based on the rationale of historical cost accounting (HCA) the original cost or purchase price of an asset. This is followed by a discussion on other main accounting measurements for valuation of assets, CCA, net realisable value (NRV) and net present value (NPV). Unlike HCA, CCA introduces CCA into accounts. It recognises the effects of changes in the specific price level on the basis of replacement cost (entry prices), NRV of assets (exit prices) or its EV (NPV). The next discussion is about the asset valuation method from a utility context the deprival value. The assets of water businesses are considered sunk, as the characteristics of these assets are such that they have no alternative use; they are non-marketable and are considered as public goods by nature. For this reason, unlike the assets of a competitive market business, asset valuation in a utility business gives rise to complex valuation issues. To support these discussions, Chapter Three outlines the results of three surveys conducted in New Zealand to determine the appropriateness and consistency of asset valuation techniques used by local governments to financially report on infrastructure assets. A case study with specific reference to Sydney Water Corporation is also examined, as well as an academic research study on the effect of rate regulation on prices of other utility businesses. 3.2 The rationale for HCA The definition of HCA can be found in most accounting textbooks. In particular, Framework for the Preparation and Presentation of Financial Statements (September 2009) paragraph 100(a), defines HCA as: the amount of cash or cash-equivalents paid to acquire assets or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. 55

58 HCA assumes that money holds a constant purchasing power, as under the Generally Accepted Accounting Practices (GAAP). It is a collection of rules and procedures followed by accountants worldwide, and on the basis of financial accounting is the original cost or purchase price of an asset. All transactions are supported by availability of documentary evidence; that is, the source or original document. It is a measurement which does not change as the value changes. In accounting, it has become common practice to record historical cost of an asset as its cost on a balance sheet. The use of HCA was well-documented as early as 1494 by Luca Pacioli, often known as the Father of Accounting in his famous Summa de Arithmetica, Geometrica, Proportioni et Proportionalita in English, Everything about Arithmetic, Geometry, and Proportions. Some sections of this book served as the only accounting textbook until well into the 16 th century. The sections which are still used in accounting today and are based on HCA include the accounting cycle; the use of journals, ledgers (including the five types of accounts: assets, liabilities, capital, income and expense), year-end closing entries, and trial balances; and topics such as ethics and cost accounting. Middleditch (1918, pp ) explained that today s dollar is a totally different unit from dollar of As the general price level fluctuates, the dollar is bound to become a unit of a different magnitude. A similar observation can be found in Paton (1920, pp. 2 3). The significance of the dollar, the accountant s yardstick, is constantly changing. One of the fundamental limitations of accounting arises where the unit of measurement is always the same to allow comparisons of situations and phenomena arising at different times to be made in this field. Similarly, based on the accounting Darwinism perspective, which notes that most efficient and effective processes will survive over time, the accounting profession, academics and reporting entities have maintained partial support for use of HCA. During the first 35 years of the 20 th century, history witnessed many companies arbitrarily revalue their fixed assets to suit their immediate purposes (Sweeney 1964, pp ). By the 1930s the accounting profession adopted HCA methodology for valuing assets. Kohler (1963, p. 38) explained that despite over a decade of rejection, HCA persisted as the basis of valuation method for all assets. The executive committee of the American 56

59 Accounting Association in the 1936 Statement of Accounting Principles Governing Corporate Reports said: Accounting is not essentially a process of valuation, but the allocation of historical costs and revenues to current and succeeding fiscal periods. There seems to be no sound reason for repeated adjustments of asset values for ordinary changes in price levels commonly experienced from one generation to another. A history of cost and cost amortisation is a consistent record of actual occurrences. It constitutes an essential starting to financial interpretation. The Australian Accounting Research Foundation (AARF) maintained that: It is difficult to construct a theory which will provide a rationale for selective departure from the historical cost basis (Australian Accounting Research Foundation 1994, p. 16). Paragraph 101 of Framework for the Preparation and Presentation of Financial Statements (September 2009) states that HCA is the preferred method predominantly used today, but that some entities are allowed to use the current cost basis as the HCA model fails to deal with the effects of changing prices of non-monetary assets. Only recently, the conceptual framework and Australian and International Accounting Standards, IAS 16/ AASB 116 Property, Plant and Equipment (June 2009) introduced elements of current value or fair value measurement for asset valuations. Lee (1985, pp ) reported that accounting income calculated according to historical cost has the benefit of a sound, factual and objective transactions base. This is because the recording of historical costs may be factual, but the accompanying conventions of the realisation principle, the notion of conservatism and the matching principle introduce judgement into recognition of revenue and allocation of costs. The reported income figure is a heterogeneous mix of gains of the current and prior periods and not just the straightforward, factual number which it is sometimes claimed to be. McCarthy (2004, pp ), on the other hand, believed that the reliability offered by historical financial reporting is infinitely more valuable. Flegm (2005, pp ), 57

60 meanwhile, argued in favour of HCA-based valuations because of the inherent objectivity associated with such measurements. The world s largest frauds in management history were initiated by the move towards fair (market) value accounting. Another similar concern of using fair value estimates is that overstatements of their valuations can lead to the collapse/bankruptcy of companies. This concern was raised by Benston (2006, pp ), who used the example of Enron and Harris and Kutasovic (2010, pp ), suggesting that Lehman Brothers, the largest bankruptcy (2008) ever filed in the United States, was a result of fair value accounting (FVA). Mautz (1973, pp & 93 98) identified that the nature of accounting as a service activity has been widely influenced in more recent times not so much by the accountants, but by business people. That is, those who make management and investment decisions had not found financial reports based on historical cost useful over the years, changes in accounting would have long since been made. However, this still does not mean there are no other asset valuation techniques that are better than HCA. The common error made by proponents of decision-usefulness studies is that they either attempt to provide support for or rejection of particular respondents or users based on those respondents or users indications on whether HCA would or would not be useful for their particular purposes. Gray, Owen and Adams (1996, p. 75) asserted that: Decision usefulness purports to describe the central characteristics of accounting in general and in financial statements in particular. Often there might be things that can be more useful but failed to be looked into by respondents. Henderson, Peirson and Herbon (2008, pp ), in contrast, stated that HCA maintains financial or money capital intact, and that it ensures that the value of an investor s initial capital investment can be preserved. Pursuant to paragraph 9, IAS 2/ AASB 102, it is a requirement for entities to measure their inventory at the historical cost or net realisable value, the amount of cash that could currently be obtained by selling the asset in an orderly disposal; whichever one is the lower. Out of the 10 characteristics of Qualitative Characteristics of Accounting Information, HCA outperforms the FVA in only two. Chapter 3 Qualitative Characteristics of useful 58

61 financial information, specifically QC (Qualitative Characteristic) QC30-32 of CF Amendments to the Australian Conceptual Framework (January 2014) recommend that accounting information must be understandable to users who are generally assumed to have a reasonable knowledge of business and economic activities. This advantage is obtained simply by the usage and longstanding common practice of HCA (Hanselman 2010, p. 10). Moreover, verifiability, which is a function of reliability, is defined in Chapter 3 Qualitative Characteristics of useful financial information, specifically QC26 of CF Amendments to the Australian Conceptual Framework (January 2014) or the United States Statement of Financial Accounting Concept, SFAC 2 (SFAC 2, cited in Deegan 2006, p. 193) as the ability through consensus among measurers to ensure that information represents what it purports to represent. Daines (1929, p. 98) argued that that HCA has its greatest advantage because this original cost method is most easily subject to objective verification and is the easiest to use in practice. Accounting information can be verified by reference to an original or source document. HCA, the costs incurred upon acquisition, is assumed to be unquestionably highly verifiable. HCA will have gained the verifiability advantage, as the information is certain to be confirmed by several independent evaluators. The original purchase price is fixed and can be easily verifiable or determined by third parties, such as auditors. A number of scholars such as Edwards and Bell (1961), Chambers (1966), MacNeal (1970), and Lee (1996) have all criticised, raised concerns and questioned the relevance of the application of HCA to current economic decisions in their published books. Such criticism occurred during high-inflation periods of the 1950s to early 1970s and 1980s. The criticism caused the accounting standard setters in a number of countries, including Australia, to consider some modifications to HCA in order to provide more relevant accounting information to users. Most notable among the criticisers is Chambers (1966, pp ), who argued that HCA information suffers from problems of irrelevance in times of rising prices. Chambers raised the question of whether it is useful to be informed of the cost of a 59

62 particular asset purchased many years ago when the asset s current value reflected by its replacement cost or current market value is considerably different. Graham and Xavier (1987, p. 19) revealed that it has long been recognised that accounts drawn up on HCA are misleading, especially where assets are long-life and inflation is significant. Balance sheet figures of original cost do not represent the value of assets to the business, while profits and financial trends are also misrepresented. Accounts which show resource use and economic performance must allow for general inflation, fluctuations in specific prices and costs, and for technological progress as a result of changes in the value of capital equipment. There is, however, a real problem of additivity. Government trading enterprises such as water businesses have a high proportion of long-lasting assets ( years) that are purchased and invested at various points of time, and these assets are subject to different price levels. The issue here is whether it is logical to add together assets acquired during different time periods when those assets were acquired with a different purchasing power. Historical cost figures may have limited application under such conditions (Lee & Fisher 2004, p. 351). Graham and Xavier (1987, p. 19) argued about a similar concern, where they claimed that balance sheet figures of HCA conventions are misleading, especially for long-life assets. Since HCA does not take into account the effects of factors such as inflation on the value of capital assets, it often leads to both capital value and capital costs being underestimated, which therefore results in overstated rate of return on the entity s assets. Other shortcomings are summarised by the International Accounting Standards Committee, which was later replaced by IAS 29/ AASB 129 Financial Reporting in Hyperinflationary Economies (June 2009). Paragraph 2, IAS 29/ AASB 129 reads: In a hyperinflation economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses purchasing power at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within same accounting period, is misleading. 60

63 Elliot (1986, p. 33) asserted that the HCA is an implicit and troublesome assumption model where the monetary unit is fixed and constant over time. Elliot also identified three components of modern economy that make this assumption less valid than it was at the time the model was developed. Firstly, the specific price-level changes occasioned by technological advances and shifts in consumers preferences; secondly, the general price level changes (inflation); and thirdly, the fluctuation in exchange rates for currencies. According to Elliot, the book value of a company, as reported in its financial statements, only coincidentally reflects the current value of assets. Reflecting on the lack of agreement on this issue and relying on metaphors associated with evolution, Elliot (1986, p. 35) claimed: There is growing evidence in the market place that the historical cost basis information is of ever declining usefulness to the modern business world. The issue for the financial accounting profession is to move the accounting model toward greater relevance or face the fact of the dinosaur and the messenger pigeon. 3.3 The rationale of CCA Apart from the HCA, the other main accounting measurement for valuation of assets is the CCA. CCA, unlike the HCA, introduces current costs into accounts and recognises the effects of changes in a specific price level on the basis of replacement cost (entry prices), NRV of assets (exit prices) or its EV (NPV). The current cost of stocks including its depreciation is added to arrive at CCA operating profit. The replacement cost is the cheapest possible replacement, by the use of modern equivalent assets (MEA); while the recoverable amount is the higher of net disposal price (net realisable value) or present value of the additional cash flows, as a result of the retention of the assets (NPV). A pure CCA system does not include appreciation of stocks and fixed assets, known as holding gains. This accounting approach to capital maintenance is based on maintaining the operating capability of a business. CCA uses an operating capability concept of capital maintenance. Profit is recognised only after charging for maintenance of real operating (physical) capability of the business, as assets are valued at their value to the 61

64 business. In other words, the business would suffer a loss if it were to be deprived of the use of the asset. Most economists and some accountants, such as Sweeney (1936, pp ), Edwards and Bell (1961), Chambers (1965, p. 736), and Sterling (1970), have advocated the use of CCA to valuing assets. However, many of these scholars have raised a similar concern about the basic problem with the use of CCA. That is, it is difficult to determine exactly what the correct concept is for CCA. Table 3.1: Comparison of traditional HCA and CCA Traditional HCA CCA Sales $ 150 Sales $ 150 Less cost of goods sold 100 Less current cost of goods sold 125 Profit 50 Profit 25 We can observe from Table 3.1 above, under the traditional HCA, that profit is $50. Under the CCA, cost of goods sold, after the charge of current replacement cost of the commodity (bananas), is $125; profit after deduction of current replacement cost is $25. Assume that inflation exists at a rate different from that of the change in the price of a specific commodity; in this example, bananas. If this is the case, realistically the owner should aim at maintaining their real wealth that is their command over goods and services in general before recognising profit. Assuming that inflation exists at a rate of 10 per cent and affects the change in the price of bananas, we would regard the owner s closing capital requirement as $110 ($100 X 1.1) and profit as $40. When the calculation is rearranged, profit is arrived at as the table on the left: Table 3.2: Comparison of Constant Purchasing Power Accounting (CPPA) and combination of CCA and CPPA CPPA Combination of CCA and CPPA Sales $ 150 Sales $

65 CPPA Combination of CCA and CPPA Less cost of goods sold 110 Less current cost of goods sold 125 Profit 40 Operating profit 25 Add real holding gain on stock 15 Profit 40 In this example (refer to Table 3.2 above), we see the application of CPPA, which was advocated by the accounting profession in 1973 (Singer 1991, pp ). Its definition can be found in International Accounting Standard IAS 29/ AASB 129 Financial Reporting in Hyperinflationary Economies (June 2009). Under CPPA, only constant real value, non-monetary items, such as shareholders equity (not variable real value, nonmonetary items), are measured in units of constant purchasing power during low inflation and deflation respectively. Accountants can choose CPPA to implement a financial capital concept of invested purchasing power; that is, the financial capital maintenance in units of constant purchasing power during low inflation and deflation, instead of the traditional HCA concept of invested money. Profit can also be presented in an alternative way as shown in the right column in Table 3.2 above. This yields the same profit figure as the CPPA example. However, it also shows how the profit was alternatively made, which provides more information and might assist the owner towards a better understanding of how the gains were derived. Firstly, we can tell the owner of the current cost operating profit is $25. $25 ($150 $125) is the cash profit (also known as holding gain in money terms), which would have been made if the stock was bought at current prices. However, as this was not the case here, they saved money by doing so. We would then subtract this $25 from $10, which is the allowance for inflation, the general devaluation of money, which has taken place since the purchase. Important information which combines the useful features of both CCA and CPPA enables the ability to distinguish profit statements between the nominal holding gain and the adjustment for inflation. Logically, business profit will show how the entity has gained in financial terms from the increase in cost of its resources, which is a limitation of 63

66 the HCA. These useful features have been advocated by many other great pioneers of inflation accounting, such as those of Middleditch (1918). On one hand, Middleditch (1918, p. 119) explained that if a business has assets consisting mainly of money items, it naturally will suffer from rising prices. Alternatively, if it mainly had goods, then it will be benefit from rising prices. It has since been built on in the past six decades, and became the seed for an idea that gradually formalised in most of the prescriptions for general price-level adjustments. Historically, this was Middleditch s only contribution, but his views were kept alive through references to his 1918 article by well-known scholars such as Paton and then Sweeney. Paton referred to Middleditch s work and explained that it was not unreasonable for accountants to prepare supplementary statements, to show by making proper allowances for the change in the value of money, which is the true comparative economic status of the business (Paton 1922, p. 429; Mills 1926, pp. 3 4). Similarly, Sweeney s work in 1927 and 1931 made considerable advances over other earlier attempts (e.g. Paton (1922) in his accounting theory book) by refining the process of price-level adjustments. Both Sweeney (1927, p. 185) and Hayek (1941, pp ) favoured the general price-level adjustments and related maintenance of real financial capital intact concept. They argued that the maintenance of nominal capital, which is overlooked when money is depreciating in value, may be kept intact by maintenance of same money, which may be maintained by constant ownership of the same amount of material quantities. In line with this, maintenance of value, not only physical equivalence ensures preservation of the same economic power over goods and services, and such preservation, which is maintenance of real capital, is much more worthwhile. Paton and Paton (1952, p. 325) emphasised the replacement of productive capacity of assets; the replacement cost-new is equal to the amount of cash or other consideration needed to replace or reproduce the productive capacity of an asset with a new asset reflecting changes in technology. They considered the alternative of replacement of an existing asset with an asset of equivalent capacity: 64

67 It should be understood that the significant replacement cost is the cost of providing the existing capacity to produce in terms of the most up-to-date techniques. It is a waste of time to estimate the cost of replacing an obsolete or semi-obsolete plant unit literally in kind. Such an estimate will never afford a basis for a sound appraisal of the property nor furnish a useful measure of current operating cost. What is of interest is what it would cost to replace the capacity represented in the existing asset with a machine modern design. Put differently, the cost of replacing in kind is a significant basis on which to measure the economic importance of property in use only in the case of standard, up-to-date facilities. In contrast, two other important theoretical writers, Edwards and Bell (1961, p. 286) attached a current value to income by including changes to buying prices and general purchasing power. Their model was consistent with the CCA model example described above, and paragraph 104(a) of AASB Framework for the Preparation and Presentation of Financial Statements, (December 2009), which notes that all non-monetary assets have to be adjusted to their respective replacement costs. An important feature of their model was that they were able to develop a pragmatic solution to the problem of inflation that was not only palatable to practitioners, but also useful for managerial decision-making and evaluations of managerial performance by external users. Their model focused on replacement of an existing asset with an identical asset. It not only provided support for replacement costs, but it was specifically explicit in acceptance of traditional GAAP s going concern convention: It must be remembered that it is not the current cost of equivalent services provided by fixed assets over some time period which we wish to measure but the current cost of using the particular fixed asset which the entity chose to adopt and is still using. This is the particular decision that the entity wishes to evaluate on the basis of accounting data. It is possible that he then might wish to compare these data with opportunity cost data which relates to selling and/or replacing the fixed asset. So that he can make decision about the future, he must have information about the actual present and past. 65

68 Later in 1975, the Consultative Committee of Accountancy Bodies advocated in practice by in their response to the Sandilands Report that some features of the current cost are incorporated in the current United States standard on accounting for changing prices, Financial Accounting Standard, FAS 33 in 1979 (Whittington & Zeff 2007, p. 201). Beildelman (1973, pp ) noted that the application of CCA can be seen across many accounting literatures in Australia. The 1970s in particular was an active period in the development of a comprehensive system of CCA in Australia. The driving force in the practice of CCA was high inflation rates in Australia, particularly in the mid-1970s when it was around 12 per cent. There was also a growing body of Australian and international literature recommending abandonment of HCA and movement towards CCA by international standard-setting bodies. Additional influence of CCA can be found in the Mathews Committee on Inflation and Taxation, which was appointed by the Australian Government in December 1974; subsequently, the Mathews Report was issued in May This report contained submissions, public hearings and final recommendations that undoubtedly indicated some significant public support for practice of CCA in Australia (Barnea, Ronen & Sadan 1976, p. 111). The support for CCA s underlying principles has also been strongly endorsed by the AARF, as evidenced by some of its activities. By far, Australian history has witnessed the release of three exposure drafts on CCA from 1974 to These three exposure drafts were: ED 7 Accounting for Changes in the Purchasing Power of Money, issued in December 1974; ED 9 A Method of CCA, issued in June 1975; and ED 10 The Recognition of Gains and Losses on Holding Monetary Resources in the Context of Current Value Accounting, released in July Next was ED 15 current cost accounting, which was a collection of exposure drafts issued and suggested for expansion of the Provisional Accounting Standard. CCA has also been subjected to public lobbying by some influential organisations, such as the Institute of Directors. In late 1978, the Institute of Directors issued a critical review of CCA exposure drafts by making specified references to the lack of support for CCA regulations, the level of subjectivity of information produced, and the lack of guidance of 66

69 CCA disclosures to company shareholders (American Institute of Certified Public Accountants 1974, p. 26). However, CCA was issued as the Statement of Accounting Principles, SAP 1 in November 1983, which was amended in Even though it is obvious that it was subject to criticism by certain bodies and institutions, the AARF appeared to have found enough support to justify the issuance of SAP 1. The requirements of SAP 1 are relevant in the public sector, particularly because they recommend the use of written-down current cost of an asset, where market buying prices are not available, which is relevant to longlife infrastructure assets. Previous Australian accounting standards, which have permitted or recommended the use of replacement cost accounting and make reference to SAP 1 include AAS 27 Financial Reporting by Local Departments, AAS 29 Financial Reporting by Government Departments, and AAS 31 Financial Reporting by Governments. Until recently, following the move to International Financial Reporting Standards (IFRS), the Australian Accounting Standards Board (AASB) moved steadily away from a replacement cost approach towards fair (market) value accounting. Jones and Riahi-Belkaoui (2010, pp ) suggested that the CCA provides better comparability of various entities performances, as one entity s profits are more realistic not simply because it bought assets years earlier and would have generated lower depreciation under HCA. However, under CCA it is difficult to determine replacement costs, which makes it just as arbitrary as it is with HCA. In relation to infrastructure assets such as water, past costs are sunk costs. Water businesses might decide to replace a given asset, as it might be more efficient and less costly to acquire these different types of assets. If this is the case and the businesses were required to acquire this new asset, replacement cost is irrelevant, as it does not reflect what it would be worth if the business decided to sell it. Likewise, Chambers, an advocate of CCA and founder of Continuously Contemporary Accounting (CoCoA), was particularly critical of the Edwards and Bell model of accounting. Both Chambers (1995, p. 82) and Clarke (2000, p. 276) have stated: 67

70 In the context of judgement of the past and decision making for the future, the products of CCA of the Edwards and Bell variety are irrelevant and misleading. 3.4 The rationale of value-based accounting method NRV The two common value-based accounting models for asset valuations are NRV accounting and NPV accounting. Edwards and Bell (1961, p. 75) defined NRV accounting of an asset as its current exit value ; that is, the maximum price a currently held asset could be sold for in the market, less the transactions costs of the sale. Lee (1985, p. 14) described it as representing the opportunity cost of assets, or the value of a resource in its next available form. The Framework for the Preparation and Presentation of Financial Statements, paragraph 100(c) (December 2007), defines realisable (settlement) value as assets carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlements values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business. Paragraph 101 specifies that inventories are usually carried at the lower of cost and net realisable value. The concept behind NRV accounting lies within the periodic change in the realisable value of capital, which is directed towards maintenance of financial capital. Those who support NRV accounting include Chambers (1966), MacNeal (1970) and Sterling (1970). The most notable form of this capital maintenance was developed by Chambers, now known as the CoCoA model. Chambers suggested that assets should be reported at their exit prices or realisable market value; that is, either cash or cash equivalents that would currently be obtained from sale or when sold in the normal course of business. The CoCoA model highlighted that liabilities should be reported at the undiscounted amounts of cash or cash equivalents that the entity expects to pay, in order to satisfy the liabilities in the normal course of business. 68

71 In fact, Lee (1985, p. 92) found NRV accounting to be advocated as the most reasonable opportunity cost to use, (as) it is an expression of economic sacrifice being made by an entity when it invests in resources it has rather than in its alternatives. Such a sacrifice is therefore expressed in terms of the entity s ability to command alternative goods and services. In practice, NRV accounting, unlike the HCA, lacks objectivity. Sterling (1970, p. 328) defined NRV accounting as forced liquidation value, rather than a going concern notion. That is the price that could be obtained by selling to the first man on the street that happened to meet or like two accountants attempting to construct net realisable values for a firm s assets. They would not generally come up with the same values the market values are not easy to obtain and it would be absurd to report such values. Sterling therefore called for a less radical notion of exit price or NRV accounting. On the contrary, NRV accounting has some advantages. The idea of money worth in regard to assets is undeniably understandable. It highlights the fact that businesses do have a choice in relation to the assets they hold. The NRV accounting also provides a measure of such alternative choices, together with the current sacrifices implied in holding the chosen resources. The concept of NRV accounting is consistent with the maintenance of financial and physical capital. It has been presented in the CCA debate as a measurement concept which provides an indication of both adaptability and liquidity (Gibson & Goyen 1996, p. 61). 3.5 The rationale of value-based accounting method NPV The view where the appropriate value for an asset is the discounted stream of future net revenues or NPV accounting can be attributed to the work of Fisher and Canning. Fisher (1897, p. 527) maintained the flow of services from an article of capital of any duration or distribution of rate as the discounted value of its anticipated services, while Canning (1929, p. 207) stated that: 69

72 If one could approximate the future of series of money outgoes and of money receipts of a business, one could find, given a rate of discount, a direct capital of that business. To add to this, Des Jardins (2001, p. 78) pointed out that the practice of discounting future interests finds a contemporary expression in the economic concept of discounting the present value of future payments. One dollar held now is worth more than one dollar held at some time in future, because we could invest that dollar today, earn interest on it, and therefore have more than one dollar at a future date. Future dollars must be discounted to be equivalent to present value. The Framework for the Preparation and Presentation of Financial Statements, paragraph 100(d) (December 2007), defines NPV accounting as assets carried at the present discounted value of future net cash inflows that an item is expected to generate in the normal course of business. That is, liabilities are carried at present discounted value of future net cash outflows that are expected to be required to settle the liabilities in the normal course of business. Accountants have traditionally been concerned with income calculations based on market transactions and prices. The NPV accounting is an economic concept based on prediction of future cash flows. According to Lee (1985, cited in Gibson & Goyen 1996, p. 62) valuation of capital on the basis of discounted future net cash flows is believed to be the measurement model that is closest to the economists idea of true or ideal income. In theory, the NPV accounting model is considered the best model. This approach includes within the income calculation all cash flows, while the traditional HCA measures include only those gains which have been realised. In the event that the forecasted flows are accurate, the main difference between the economists and accountants income measurement techniques is simply the periodic differences. Gibson and Goyen (1996, p. 62) asserted that these timing differences will self-cancel by the end of the asset s or the entity s life. However, NPV accounting is recognised for its practical deficiencies. For instance, it requires not only an estimate of future net cash receipts and the timing of those receipts, 70

73 but also the selection of appropriate discount rates. Although they are conceptually preferable, the subjectivity and the uncertainty surrounding their use make their implementation impractical (Raar 2008, p. 798; Jones & Riahi-Belkaoui 2010, pp. 455 & 471). 3.6 The rationale of FVA The FVA first arose in the 1890s utility rate base setting context; namely from the 1898 United States Smyth v Ames utility pricing judgement. Consumer bodies were in favour of a rate base that reflected lower prices, the current costs, but the monopoly utility companies were in favour of the historical or higher costs. The fair value rate base was therefore the monetary amount considered fair and reasonable to both operators and consumers according to the circumstances of that time. Most recently, the ideas and practices underpinning initial understandings of FVA have changed from the initial concept of the utility rate-setting context to that of corporate financial reporting. The definition of FVA can be found in paragraph 6 of IAS 16/ AASB 116 Property, Plant and Equipment (June 2009), and the equivalent paragraph 9 of the IFRS 13/ AASB 13 Fair Value (September 2011), as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm s length transaction. This definition of FVA is consistent with the term adopted in other accounting standards. Paragraphs of IAS 40/ AASB 140 Investment Property (October 2010), further defines knowledgeable as both the willing buyer and the willing seller who are reasonably informed about the nature and characteristics of the particular asset (or group of assets), its actual and potential uses, and market conditions at the reporting date. A willing buyer is motivated but not compelled to buy. This buyer is neither over-eager nor determined to buy at any price, and hence would not pay a higher price than a market comprising of knowledgeable, willing buyers and sellers. A willing seller is neither an over-eager nor a forced seller, prepared to sell at any price, nor one prepared to hold out for a price not considered reasonable in current market conditions. The willing seller is motivated to sell the asset at market terms for the best price obtainable. An arm s length 71

74 transaction is the one between parties that do not have a particular or special relationship that makes prices of transactions uncharacteristic of market conditions. The transaction is presumed to be between unrelated parties, each acting independently. Supporters of FVA such as Barth, Landsman and Wahlen (1995, pp ) have asserted that fair value is relevant, because it reflects present economic conditions related to economic resources and obligations; that is, the condition under which financial statement users will make their decisions. In recent years, a major new influence on the process of setting accounting standards has emerged. The global financial crisis of placed the accounting standards setters such as the United States Financial Accounting Standards Board (FASB) and the IASB under pressure to change those standards related to fair value measurement for financial instruments. The use of FVA has been blamed for the collapse of major financial institutions such as Lehman Brothers, the largest mortgage bond underwriter in the United States. On 15 September 2008, Lehman Brothers was declared bankrupt with a debt of over $US613 billion (Dow Jones Newswires 2008; MarketWatch 2008). Its collapse provoked turbulence not only in the financial markets, but more importantly to the world of IFRS. Around the same time, Merrill Lynch, headquartered in New York City and occupying the entire 34 floors of the Four World Financial Center in Manhattan, agreed to sell itself to Bank of America for $US50 billion; a price representing a discount of 61 per cent from its September 2007 price (Poirier & Comlay 2008; France Agency Press 2008). These events raise important questions on the impact of FVA during current financial crisis. The global financial crisis has significantly raised the level and stakes of discussion on the contrasting views for and against the use of FVA, which is increasingly under attack and subject to intense discussion and debate. Magnan (2009, pp. 1 16) argued that FVA is difficult to verify and might be based on unreliable assumptions or hypotheses. FVA provides management with too much discretion in the preparation of financial statements, and is not only easy to manipulate but is also unstable; hence making it unsuitable to be used as an estimate for value of an asset. It is difficult to make an estimate based on flows 72

75 expected in future from use of a specific asset. FVA is associated with more volatile and less conservative financial statements. Although its use is based on present value or exit price estimates, and it has been adopted universally by accounting standard setters, it previously led and contributed to Enron s failure (Benston 2006, pp ). Likewise, troubled firms in the United States such as Lehman Brothers and Merrill Lynch were forced to sell their assets, creating an artificially low industry standard for the value of their assets (Gwilliam & Jackson 2008, pp ). In relation to determination of FVA for property, plant and equipment, which includes water infrastructure assets, paragraphs 33 and 34 of IAS 16/ AASB 116 Property, Plant and Equipment (June 2009) and the equivalent paragraph 62 of the IFRS 13/ AASB 13 Fair Value Measurement (September 2011) provide the following guidance: Fair value of items of property, plant and equipment is usually their market value determined by appraisal. If there is no market-based evidence of fair value because of the specialised nature of property, plant and equipment and the item is rarely sold (this is applicable to water infrastructure assets), except as part of a continuing business, an entity may need to estimate fair value using an income or a depreciated replacement cost approach. If this is the case, international and Australian accounting standards allow fair value to be estimated using an income approach or a depreciated replacement cost (DRC) approach. No further guidance in the Accounting Standard is provided or can be found as to whether both techniques are equally acceptable to all entities in all circumstances, or whether each of the available techniques should only be applied in certain circumstances, as appropriate. 3.7: The rationale of the use of ODV in utility businesses The ODV, a variant of the deprival value, is the lesser of the DORC and the EV of the asset. Bloom and Debessay (1987, p. 159) established that very few firms have applied 73

76 the deprival value in their asset valuation, with the exception of utilities, and that presumably the deprival value approach estimations are extremely difficult. In particular, the estimation of present value is subjective to varying degrees. Supporters of the deprival value were generally accounting theorists such as Baxter (1971, p. 36; 1975, pp ; 2003, pp. 1 23), Edey (1974, p. 75) and Solomon (1966, p. 127, cited in Johnstone & Gaffikin, p. 51). In Australia, the institutional history of the deprival value has been documented by Clarke (1998, pp. 8 16), and Walker, Clarke and Dean (2000, pp. 1 32). Walker, Clarke and Dean (2000, p. 2) asserted that adoption of deprival value accounting by government trading enterprises has occurred only after limited debate within the public sector. Walker, Clarke and Dean (2000, p. 132) reported that deprival value accounting, a variant of replacement cost, has become the dominant public sector accounting method. In fact, since a COAG agreement in August 1994, it is now recognised as the preferred valuation method for network assets (Independent Pricing and Regulatory Tribunal 1998, p. 35; Australian Competition and Consumer Commission 1998, p. 8, cited in Johnstone 2003, p. 3). Outside of Australia, similar developments in the United Kingdom have been discussed by Whittington (1994, pp ; 1998, pp ), while Baxter (2003, pp. 1 21) outlined conventional thinking in the use of deprival value accounting. Prior to that, there were virtually no debates at all within the technical journals of the accounting profession. Dean 1998 (pp. 1 2) argued that there appear to be no published research into the appropriateness or serviceability of this form of reporting to guide decision-making, or for any other purpose in the private or public sector. Interestingly, it has been noted that the limited local debate pays no attention to post-1980s United Kingdom literature on alternative forms of CCA and especially more complex for government trading enterprises. The initial formulation of replacement cost accounting was the idea of an Austrian economic in the later part of the 19 th century. It resurged in Europe in the 1920s, before dying down in the 1970s because there was little or no attention given to concerns about ensuring the maintenance of physical operating 74

77 capability (Deans & Wells 1979 and Tweedie & Whittington 1984, cited in Walker, Clarke & Dean 2000, p. 2). In the 1990s, Australia applied CCA for all government trading enterprises. It appears to have been initially motivated by a desire to use replacement cost as a surrogate for EV, also referred to as the recoverable amount. The Canadian Accounting Standard pronouncements asserted in paragraph A.27 that deprival value measurements are surrogates for present value of cash flows from use of the assets in question (Bloom & Debessay 1987, p. 159). This resulted in denominator and numerator rates of return of asset calculations, and established demanding rate-of-return targets for government trading enterprises, and such data could be used to legitimise rate increases (Victorian Government 1986 and Swan 1989, cited in Walker, Clarke & Dean 2000, p. 2). The first deprival value approach, with application of optimisation (ODV), was undertaken by Transpower, an electricity transmission company established on 1 July 1994 after the separation of the Electricity Corporation of New Zealand into transmission and generation companies. In 1992, both the accounting firm Ernst & Young and Oxford Research Associates were engaged in undertaking a study regarding asset valuation of the transmission company. The ODV was chosen as the asset valuation method for Transpower for two major reasons. Firstly, it allowed Transpower to attract private capital for all necessary replacements, as the price of assets is set at levels below the ODV, where it is sufficient to finance bypass (duplication of network). A large number of producers compete with each other in a competitive market to meet the wants and needs of a large number of consumers. The ODV is considered the best method because it mimicked a long-run competitive equilibrium where no business in the industry will want to leave and there is no reason for entry. The implications of a long-run competitive equilibrium are that no existing business will incur a loss, but any potential business that entered the market would (Salisbury 1998, p. 1; New Zealand Institute of Economic Research (INC.) 2000, p. 4). Competitors would build a second network if Transpower s prices were above the ODV levels. 75

78 Secondly, the ODV minimises the required regulatory oversight of the business. A price cap is imposed to provide incentives for efficient investment, which would allow investors to be able to see cash flows in place, making it sufficient for any replacements (New Zealand Institute of Economic Research (INC.) 2000, p. 4). It was necessary to separate both the transmission and energy pricing, and the value for Transpower s asset needs to be derived for separation to take place. The ODV was recommended as the best valuation methodology, even though the most common practice for electricity utilities in other countries at that time was to value their transmission system based on HCA. Most importantly, the New Zealand Government required the electricity line companies to provide ODV valuation figures for the purpose of performance comparison and not for pricing. Following the adoption of ODV valuation figures into their accounts, it was observed that these companies priced their services on the basis of these much higher valuations. As discussed earlier, the concept of deprival value has been around since the 1920s. It was first developed for use in insurance and damage estimation. The deprival value is the original work of Bonbright (1937, p. 71) who stated: The value of property to its owner is identical in amount with the adverse value of the entire loss, direct or indirect, that owner might be expecting to suffer if he were deprived of the property. Bonbright s concept of the deprival value was extended by Baxter (1971, p. 36), as the lower of replacement cost or the expected direct benefits. Bonbright s concept was later broken into two parts by MacDonald (1974, p. 269, cited in Fraser 1988, p. 86), and the first part is the deprival value. This part is applicable to an owner who has lost an asset and measures the quantum of the loss. The second part is value to the owner, which applies to an owner in possession of an asset. In simple terms, deprival value is based on the legal notion of compensation for loss, including value to the owner, or entity, for accounting purposes. It represents the future economic benefits that would be foregone by the entity if it were deprived of the service potential or future economic benefits embodied in the asset. 76

79 As seen in the diagram below (Baxter 2003, p. 7; Macve 2010, p. 113), the deprival value relates to current cost or current replacement cost, the present value and the net realisable value. DV = min [RC, RA]; that is, the lower of replacement cost and recoverable amount and the higher of NRV and present value (PV), or equivalently, put together, DV = min [RC, max (PV, NRV)]. Diagram 1: Deprival value Several researchers have suggested the six valuation cases implicit in the deprival value (DV) concept, and the implications of each are presented in Table 3.3 below (Norstrom 1985, p. 265; Bloom & Debessay 1987, p. 168; Johnstone & Gaffikin 1996, p. 52; Stark 1997, p. 44; Zijl & Whittington 2006, p. 125; Weetman 2007; p. 240; Rushdi 2008, p. 7). Table 3.3: Six valuation cases, including the option to wait Valuation cases Presumed course of action and implication 1. PV > NRV > CC DV = CC; replace the asset. It may well be unlikely for NRV to exceed CC 2. CC > PV > NRV DV = PV; do not replace the asset. The owner uses the asset until it is worn out it will generate cash flows with that given PV 3. CC > NRV > PV DV = NRV; do not replace the asset. The owner sells the asset, as it seems ready for liquidation 4. PV > CC > NPV DV = CC; replace the asset 5. NRV > CC > PV DV = CC; replace the asset, which seems unrealistic 6. NRV > PV > CC DV = CC; replace the asset, which seems unrealistic PV = present value; value in use 77

80 CC = current cost NRV = net realisable value If the entity replaces the asset it has lost, the appropriate valuation base is replacement cost. Edwards, Kay and Mayer (1987, cited in Stark 1997, p. 42) suggested the replacement cost in this case refers to the cost of replacing the services yielded by an asset, and not the cost of physical replacement. If the entity does not replace the asset it has lost, the deprival value (DV) would be represented by the greater of its NRV and NPV. Stark (1997, p. 42) explained this as the option to wait. The value of the option to wait associated with an asset is the economic worth ; that is, the present value of the entity s future cash flows, which can be attributed to the opportunity to acquire the asset in future. Stark (1997, p. 42) emphasised this value as all possible opportunities to optimally invest in the asset at all feasible points in the future. Any surplus assets are measured at their net realisable value; whereas the NRV represents the deprival value of assets. He argued that it is assumed that asset markets are active to allow immediate disposal at a certain price, and that the NRV represents the proceeds from selling the assets for their scrap value. The same version can be succinctly expressed as (Weetman 2007, p. 239): DV = min [RC, RA]. Where the deprival value is represented as (DV), the replacement cost (RC) is an asset s replacement cost, and the recoverable amount (RA) is that made possible by current ownership of the asset: RA = max [PV, NRV] DV = min [RC, max (PV, NRV)] PV represents the present value in use and NRV is the NRV. Lennard (2010, p. 98) claimed that support for widespread use of deprival value (replacement cost) in many circumstances is because it represents the extent to which the 78

81 entity is better off as a result of its ownership of an asset, as long as it exceeds the price paid for the asset. A business takes into account the returns it will enjoy through the ownership of an asset and perhaps will earn by using it jointly with other assets. This would suggest that the returns from the asset should be the basis on which the asset should be measured; however, it could overstate its value to the entity. The ownership of the asset can therefore justified, as it permits the earning of future returns. Those returns lie in the future and should not be reflected in the value of an asset that is currently owned. With reference to Bonbright s definition of deprival value, it can be concluded that if the entity was deprived of the asset, it would not lose its future returns. The entity s loss would simply be the cost of replacement, which captures the extent to which the asset makes the entity better off financially. The deprival value (entry value) has some advantages over some exit value approaches, such as fair value (market value) accounting. Under fair value (market value) accounting, the asset would have been written down or sold at the price that a buyer would be prepared to pay for it. In doing so, a great deal of subjectivity is involved; in particular for specialised (infrastructure) assets such as those of utility businesses. However, fair value (market value) could result in not only scrap valuation but a significant loss for the business. The original concept of the deprival value or value to the owner as noted by Bonbright appears to be misinterpreted. As the replacement cost is not a measure of value to the owner, in a similar way the linking of Bonbright s name with deprival value derivation in many textbooks is inappropriate (Fraser 1998, p. 89). Careful re-examination of Bonbright s definition was found to have a discrepancy. The calculation of deprival value according to Bonbright ignores the indirect loss, in the case where deprival value is the replacement cost; that is, when the owner of the asset decides to replace that particular asset. Bonbright did, however, explain that based on grounds of expediency, indirect loss might be ignored. Bonbright (1937, p. 77) stated there are situations under which a court is quite justified in valuing property, for the purposes of the case at an amount which concededly does 79

82 not measure value in any sense of the term. He therefore managed to distinguish between his concept of value to the owner and what might be objectively awarded by way of compensation for loss in a court of law. Bonbright (1937, p. 93) also established that the owner may suffer important incidental losses, which cannot be avoided by replacing the property. Even though the losses are not always taken into account in an appraisal, he emphasised that it should be taken into account if the objective is to find the full value of the property to its owner. Chambers (1971, p. 66), on the other hand, found that Bonbright indicated only vaguely at value to the owner, which might take the form of a variety of measures, including the replacement cost or NRV, or some amount between those two figures, or the lower of capitalised income and a derivative of replacement cost. Careful study of Bonbright s text clearly brings out his view of value to the owner, as he concluded (1971, pp ) that the very characteristic of market value means that the concept has but a limited usefulness in the valuation of property. The essential distinction between value to the owner and market value is that the former represents a state of mind, a favourable attitude of a particular person or group of persons towards the item valued. Market value may therefore be a fairer basis than value to the owner, even if the latter could be estimated with equal accuracy and convenience. All of this means that in principle, according to Bonbright, the deprival value or value to the owner is not measurable by market values, regardless of whether these take the form of either buying or selling prices. The extracts from Bonbright s work indicate that he did not, in principle, equate deprival value or value to the owner with market values. This is because certain circumstances market value is necessary, or even a more desirable alternative. In contrast with Bonbright-derived deprival value, where value to the owner is defined as replacement cost or net realisable value, market value has been found to be adopted as a surrogate, to be accurate, in five cases out of six on the usual inequality basis (Solomon 1966; Whittington 1983, p. 132; Johnstone & Gaffikin 1996, p. 52; Stark 1997, p. 44; Rushdi 2008, p. 7). 80

83 Talking about exit value approaches, Lennard (2010, p. 98) described it as hypothesising a purchaser that is in exactly the same economic position as the entity. That ism if this exit value is recognised on acquisition, the returns that subsequently materialise will seem to be ample. However, the losses arising on acquisition can be easily an accounting fiction, as it is unlikely that the same assiduity would be employed in explaining and assessing the subsequent return. In comparison, a replacement cost approach such as the deprival value shows the asset initially at the price at which it was acquired, and compares its returns against that price; hence it will inevitably seem more modest. This is the reason why many would suggest a more realistic indication of the returns earned on the investment. Expanding on this, Baxter (1971, pp , cited in Macve 2010, p. 114) claimed that replacement cost needs interpreting, not only as the second-hand purchase price, but more generally as the adverse consequences of deprival on the present value of all future cash flows, given that asset now has to be replaced earlier than planned. It requires management estimates of optimal actions, the same as the present value concept, and hence deprival value is criticised to be too subjective. When markets get deeper, the replacement cost and the NRV become ever more readily observable. Baxter also demonstrated that deprival value must always be bound by market prices, so that the subjectivity lies in fixing where on the spectrum in-between them and including them is where deprival value lies. In doing so, deprival value and equivalently the replacement cost tend towards fair value in perfect markets, but they cope inadequately and simply compares to fair value in real-world market imperfections. Baxter s work (cited in Weetman, 2007, p. 239) on deprival value is particularly impressive, as he argued based on the first principle below. For him, deprival value was a process of computing budgets or values with and without the asset: DV - PV (with asset) minus PV (without asset) (1). In order to observe the connection between the two specifications, a familiar model was rewritten: DV = min [RC, RA], add and subtract RA = max [PV, NRV] from the righthand side, and rearranged as follows: 81

84 DV = RA + min [RC - RA, 0] (2) = RA - max [RA - RC, 0] (3). According to Baxter, deprival value is the amount in which the entity is better off from owning the asset. As observed in the above equation, deprival value is the higher (not lower) of two values. What this means is that in determining the replacement cost of a long-life asset, such as those of utility businesses, in principle it entails forecasting far into the future. Baxter highlighted the inherent subjectivity with the application of the deprival value. In October 1994, the Steering Committee on National Performance Monitoring (SCNPM) of government trading enterprises produced a monograph where it detailed the findings and recommendations of asset valuations. According to these guidelines, the deprival value concept should be adopted as the preferred asset valuation method (Steering Committee on National Performance Monitoring 1994, pp. 31 & 35; Walker, Clarke & Dean 2000, p. 3). The SCNPM (1994, p. 8) defined deprival value as value to the entity of future economic benefits that the entity would have to forgo if deprived of the asset. The value to the entity in most cases should be measured by replacement cost of the services or benefits currently embodied in the assets, given that deprival value will normally represent the cost avoided as a result of controlling the assets. The replacement cost represents the amount of cash necessary to obtain an equivalent or identical asset. This definition is similar to those provided by Bonbright (1937, p. 71) and Baxter (1971, p. 36). From a different perspective, the deprival value of assets is the lesser of the NPV of the income to be generated by the assets and their replacement cost. In adopting deprival value as the preferred asset valuation method, the SCNPM was averting the financial reporting practices of private sector entities. There is no standard that requires a consistent valuation methodology for assets, as most utility businesses would generally adopt a partial and selective revaluation of asset approach. There is inconsistency in the approach used in the valuation of assets, and hence one needs to take care in an attempt to compare the performance result of government trading enterprises, 82

85 including rate of return on assets, with bodies reporting in line with private sector practices. The SCNPM s advocacy of the deprival value is consistent only with respect to noncurrent physical assets; other asset classes, such as intangibles, marketable and nonmarketable securities, inventories, monetary assets, and research and development expenditures, are all valued according to various relevant professional pronouncements and guidance statements. In doing so, it invokes those same private sector practices that are disparaged in relation to non-current physical assets (Steering Committee on National Performance Monitoring 1994, pp & 35). The deprival value method used in government trading enterprises has been criticised by a number of scholars such as King (1966, pp. 1 28), Lawrey (1994, pp ), and Johnstone and Gaffikin (1996, pp ). A common criticism is that it involves a circularity problem, especially when an entity is not likely to replace an asset if deprived of it. In such cases, deprival value would be the EV; that is: Max [NRV, NPV]. If the entity would not replace an asset if deprived of it, an assessment is made of the maximum tariff that could be charged without the consumers disconnecting or some other barrier being encountered. The EV, the recoverable amount, is the maximum of the present value of the maximum revenue the assets can earn, minus capital and operating expenditure. This is the value to the user of an asset, or the value of the asset measured at its current net market selling value. In cases where the asset has been removed from the service, it is the present value of the NRV of the assets at the time of retirement, or its disposal value. The equation above would be unable to value assets in a competitive price for output or influence by monopoly price. If any costs increase, these should be reflected in the asset valuation and vice versa. Potential entrants should set price equal to long-run marginal costs; and where price is equal to these costs, the threat of entry provides a sufficient incentive for the incumbent firm to price close to the economically efficient price level (Troughton, Swier & Associates 1996, pp , cited in Rushdi 2008, pp ). 83

86 The RAB on which prices are based is kept equal to long-run marginal costs; and therefore prices will also equate to long-run marginal costs. Since valuation of assets under this equation is affected by monopoly rents, in terms of infrastructure regulation, monopoly rents arise where prices charged to consumers produce a return in excess of a reasonable return on capital invested. If this is the case, it would lead to an increase in production costs, which will push up the price. In such instances, the sum of deprival values for individual assets will not match the collective deprival value (Troughton, Swier & Associates 1996, pp , cited in Rushdi 2008, pp ). Likewise, where an entity does not replace an asset, this is interpreted as having surplus assets. The deprival value would cause the price to increase due to depreciation charges on assets that are not required for the current level of output. These surplus and stranded assets do not form any part of inputs used in the provision of services, and should be assigned a zero value for pricing purposes (Troughton, Swier & Associates 1996, pp , cited in Rushdi 2008, p 11). A further issue is that the existing network owner should be able to secure a return on what the network would cost to replace, not what it has actually cost. For instance, when the network owner s capital is invested in pipes, the opportunity cost is the scrap value. This is the real choice faced by a network infrastructure owner, as the network owner has used up the liquid capital and has physical capital assets, which when valued would have minimal or zero opportunity cost. In economics, these assets are sunk assets with no alternative use except as scrap, and hence the initial capital base should be close to zero. When capital has been sunk, there should be no opportunity cost, and no regulated revenue stream should be awarded to induce investment to create what already exists, or to keep in place assets which have no alternative use (Dwyer 2001, p. 45). In particular, the IPART rejected the deprival value as a valuation method, as it believed that this approach was unsuitable for price regulation of monopolies where assets would not be replaced if deprived of, or where the assets do not have a market (Australian Competition and Consumer Commission 1996, p. 12, cited in Rushdi 2008, p. 8). Under the deprival value approach, as seen its formula, the assumption is that the network owner will only replace an asset if the present value of future free cash flow generated from its 84

87 use exceeds the existing replacement cost. IPART (1996, p. 13) asserted that this assumption will not apply when a government directs the continuation of the service. Contradictory to IPART, Bertram and Terry (2000, p. 21) advocated that the use of ODV for pricing would lead to prices that are a good proxy for those that would eventuate in a competitive market where supply and demand are balanced. In a perfectly competitive market, such prices that arise reflect the real short-run marginal cost. In such instances, businesses would continue to produce additional output as long as the cost of producing an extra unit of output was less than the price they would receive. The ODV is based on prices set in a hypothetical long-term competitive market with balanced supply and demand, and short-life, non-lumpy assets. This picture simply does not translate sensibly to infrastructure assets, such as water utility businesses. On the one hand, the ODV cuts out gold-plating or past over-investment, so that investors remain responsible for some errors of judgement. Yet arguably, there is no evidence that the ODV is this efficient. It is not generally sustainable, as the correct comparison for a past investment is not the MEA now, but rather the MEA at the time when the investment was made (Bertram & Terry 2000, p. 21; Gale & McWha 2000, p. 10). On the other hand, deprival value is known as the appropriate asset valuation for government trading enterprises statutory reporting and performance monitoring purposes. It is a conservative method of asset valuation intended to prevent overstatement of asset values. If the underlying circumstances of the deprival value approach are adopted by an entity, it will provide a logical, selective means of choosing the most significant value of either an asset or group of assets according to the underlying circumstances facing the entity. Any asset valuation method involves some degree of subjectivity that is an element of estimation and uncertainty. The DORC therefore takes into account depreciation that places the risk of technological changes on the investor. It ensures consumers do not pay more than what they would be paying in a competitive market (Bloom & Debessay 1987, p. 172; Rushdi 2008, pp ). ODV is used to determine surplus capacity in an entity and to determine access prices on the basis of how much the network owner will be deprived of by not using the surplus 85

88 capacity. Deprival value may well have some theoretical weaknesses, but it is better than other known alternatives (Rushdi 2008, pp ). 3.8 Summary of main types of asset valuation techniques used across various assets Figure 3.1 summarises the main types of asset valuation techniques currently used across Australia and recommended by both international and Australian accounting standard setters. The AARF (1994, p. 13) suggested that measurement is one of the most significant contemporary issues in financial reporting. Paragraph 100 of AASB Framework for the Preparation and Presentation of Financial Statement (September 2009) proposes that a number of different measurement techniques and guidelines be employed to different degrees and in varying combinations in financial statements, for the valuation of assets. Figure 3.1: Main types of asset valuations and their associated measurement rules 1. Cash 2. Account receivable 3. Inventory 1. Face value 2. Net realisable value (NRV) 3. Lower of cost and net realisable value Asset 4. Property, plant and equipment 5. Marketable securities 6. Assets leased by way of a finance lease 7. Goodwill 8. Biological assets Measurement rule 4. Lower of 'cost' and 'recoverable amount' 5. At cost or fair value 6. At the present value of the minimum lease payments 7. At cost of acquisition (fair value), internally generated goodwill is not to be recognised 8. At fair value, less estimated point-of-sale costs (NRV) 86

89 In practice and as acknowledged in paragraph 101 of the Framework, HCA represents the dominant framework for recognition and measurement; however, this is being replaced by FVA. HCA is usually combined with other measurement bases; for example, property, plant and equipment are measured at either the lower of cost or the recoverable amount, and marketable securities may be carried at cost or fair (market) value. Figure 3.1 confirms that the international and Australian accounting standard setters appear to be moving steadily towards a fair (market) value asset valuation approach as the preferred current value model for different types of accounting transactions. There are numerous international and Australian accounting standards that require or permit the use of FVA for reporting purposes, but there is no uniform current value model for such use of FVA by all companies. Paragraph 110 of the AASB Framework for the Preparation and Presentation of Financial Statement (September 2009) suggests that the most relevant and reliable measurement to be adopted in the preparation of financial statements. Asset valuation is essential to ensure that only the most appropriate asset values are adopted to satisfy accounting statutory reporting requirements. Further information on the recognition and measurement of assets is discussed in Chapter Six of this thesis. The other applicable International and Australian Accounting Framework is SAC 2 Objective of General Purpose Financial Reporting. As of January 2014, SAC 2 was withdrawn. The relevant framework is Chapter 1 The objective of general purpose financial reporting of the AASB CF Amendments to the Australian Conceptual Framework (January 2014). Chapter 1 seeks to establish the objectives of general purpose financial reporting for reporting entities. The primary purpose of this chapter is to provide information on an entity s economic or financial performance, rather than on the reporting of social or environmental performance. Public disclosures in relation to social and environmental performance, such as information on a business corporate social responsibility and its community involvement, are not mandatory by law in Australia. Most importantly, the main qualitative characteristic of financial information is that the information should be useful for economic decision-making. In accounting, without the presence of useful financial information for economic decision-making, the central 87

90 objective of the general purpose of financial statements would be meaningless. In relation to water utility industry, users of the financial statements would be interested in the capability of the business to provide goods and services in the future (paragraph AusOB3.1). The preparation of general purpose financial reporting allows management of the business to discharge their responsibilities to make efficient and effective use of the business s resources (paragraph OB16). Accounting information is useful both for assessing the business s past and future ability to generate net cash inflows through its operations as well as useful for assessing whether income was sufficient to meet the cost and quality of goods and services (water and sewerage services) the business provides (paragraph AusOB18.1). Chapter 1 suggests that one objective of general purpose financial reporting is to communicate relevant and reliable information to enable report users to make and evaluate decisions about the allocation of scarce resources. Users of general purpose financial reports are the resource providers (water utility businesses), recipients of goods and services (consumers), and parties performing a review or oversight function (regulator) (paragraph OB 2.1). By doing so, the water business is able to discharge public accountability via maintenance of relevant and reliable information as required in its audited financial statements (paragraphs OB4 and OB16). As well, level of water rates and charges are set to take into account the cost of capital (assets) and operating expenditures, including asset deprecation (National Asset Management Steering Group 2001, p. 1.2). The main GAAP applicable to asset valuation and specifically the ODV concept are the going concern assumption and the prudence or conservatism assumption. The going concern specifics that existing business will continue to operate in the future. In contrast, the prudence convention emphasises that accountants should recognise losses in asset values as early as possible, while gains should only be recognised when it is certain and the amount is realised. In line with this, assets are to be valued so as to provide a relevant and faithful representative for economic decision-making. Accounting standards relevant to ODV are the IAS 16/ AASB 116 Property, Plant and Equipment (June 2009); particularly specific standards in paragraphs 7, and 33. Paragraph 7 proposes that the cost of property, plant and equipment shall be recognised 88

91 as an asset if it is probable that future economic benefits associated with it will flow to the entity and the cost of the asset must be measured reliably. Paragraphs recommend that property, plant and equipment (water utility s assets) should be valued at either the lower of cost or recoverable amount that is the amount expected to be recovered in future cash flows through use and/or sale of the asset. Paragraph 33 of IAS 16/ AASB 116 (June 2009) or states that where there is no marketbased evidence of fair value because of specialised nature of the item of property, plant and equipment and the item is rarely sold, except as part of a continuing business, an entity may need to estimate fair value using an income (net realisable value) or a DORC approach. These standards are the same ideas specified in the COAG published guidelines in 1994, as mentioned in Chapter 6 (Steering Committee on National Performance Monitoring 1994, pp. 3 & 42). They were also reflected in the United Kingdom Sandilands Report in 1975, where scholars such as Solomon (1966), European business economists such as Theodor Limperg and Fritz Schmidt in the 1920s, and 19 th century economist Bohm Bawerk had all introduced these same rules (Edwards, Kay & Mayer 1987, pp ; Walker, Clarke & Dean 2000, pp ). That is: The ODV = lower of DORC (replacement cost) / recoverable amount (i.e. the higher of NPV/NRV), or equivalently. 3.9 Survey and case study on asset valuation and pricing In Australia, academic research in relation to asset valuation and pricing specifically related to utility businesses is very limited. Most of the published work in this area can be accredited to three accounting academics: Clarke (1998, pp. 8 16), and Walker, Clarke and Dean (2000, pp & 2000, pp ). The main issue identified in most of this asset valuation and pricing research is the need to reduce the degree of subjectivity behind the deprival value method. It is also 89

92 recognised that because most valuation techniques have an element of estimation and uncertainty, consideration should be given to the development of industry-specific guidelines, including the practical approach to optimisation. For instance, the treatment of surplus capacity, planning horizon and technological change are examples of this practical approach. Further clarification is also required on requirement for discount in the application of economic valuation/ recoverable amount tests. A great deal of concern has been raised regarding conceptual and implementation issues of asset valuation; in particular, many respondents have expressed their concerns about the application of deprival value in relation to long-life assets. The omission of the notion optimisation can change the asset value, which is subject to optimisation and is based on a greenfield approach that may result in substantially different asset values compared with like-for-like replacement costs. Such concerns are similar to those raised by Johnstone and Gaffkin (1996, pp ), including the internal inconsistencies approach to valuation of assets, conceptual limitations regarding net revenue allocation, non-additivity of deprival values, and the undefined concept of capital. In relation to the conceptual limitations, the ODV, as previously discussed in this study, is a function of three arguments : the replacement cost, the NRV and the NPV. NPV is known to be the most problematic, as an asset s NPV is difficult to assess because it needs to be allocated from projected net income stream, flowing to the surrounding profit centre or entire entity and the revenues (and costs) attributable to that particular asset. If such allocations can ever be made, they should be based on a true cause and effect foundation. In real-world circumstances, where individual assets interact, the deprival values are generally nowhere near additive. For instance, if a business has 20 machines and one machine is destroyed by fire, then the business will probably cope and be reasonably content if the deprival value, which would be the replacement cost of that machine, is paid by the insurance company. If 10 or 20 machines were lost, this might cause production to drop, customers to disappear and the business as a whole to be ruined. In such cases, the owner would clearly need more than 10 or 20 times the deprival value of 90

93 that one machine if they were to be indemnified. Expressed another way, deprival value of the business is much greater than the sum of deprival values of its part. The SCNPM (1994, p. 33) provided a response to such concerns in noting that deprival value is the sum of the individual deprival value and the best available surrogate for the value of the entity as a whole. Many scholars have claimed that there is also the unanswered question of concept of capital. Johnstone and Gaffkin (1996, p. 60) asserted that the most important error of omission in the SCNPM guidelines is that no particular capital maintenance objective is explained. Similarly, the Sandilands Report in 1975 was also found to be lacking of this concept. To take this discussion further, three surveys were carried out in New Zealand in relation to asset valuation and pricing. The first was a survey of New Zealand local authorities to study the procedures and techniques for recording and valuing infrastructure assets. The second was carried out to determine which asset valuation approach is more adopted, how is it applied, and what, if any, innovative approaches are being adopted that are more appropriate and would lead to more consistent infrastructure valuation practices. The findings of the first survey indicated that progress had been made towards greater consistency in accounting for and valuation of local authority infrastructure assets. That is, more local authorities now keep a record of assets owned, from 90 per cent in 1996 to 100 per cent in Infrastructural asset valuations are also performed more regularly compared to the 1996 study, which is 90 per cent versus 68 per cent previously (Bond & Sakornvanasak 2006, pp ). The first survey revealed that nearly three-quarters, which is 73 per cent of the respondents, revalue their asset only every three years. The replacement cost approach is the valuation methodology employed for infrastructural valuation, and 94 per cent of the respondents indicated that DORC is used, while the remaining 6 per cent use DRC. The second was a comprehensive survey on current practices in the valuation of a wastewater treatment plant of a local authority infrastructural asset. This survey was designed according to the results obtained from the first survey, particularly to identify any problems encountered in performing the DORC calculation. The first section of the 91

94 survey consisted of general questions related to utilisation of the DORC approach. The second section comprised of more specific questions on the DORC approach and how it relates to the valuation of the wastewater treatment plant. The results of the second survey revealed that valuation approaches underlying the DORC method are not consistent in deriving an appropriate valuation figure for financial reporting purposes. Some of the inconsistencies include the componentisation level used in DORC valuation and the application of appropriate approaches required to derive the replacement cost, optimised figures, remaining useful lives and depreciation rates. These inconsistencies highlight the need for further research, initiatives and guidelines so that infrastructural asset valuation can be performed accordingly (Bond & Sakornvanasak 2006, pp. 45 & 47). The third survey was conducted to assess the extent and quality of disclosure in the annual reports of the New Zealand electricity retail and distribution (or lines or network) company. Following electricity (Information Disclosure) Regulations 1999, electricity line companies are required to report the ODV of their network assets to their regulator, the Ministry of Economic Development (MED). It was revealed that disclosures on the ODV method of network assets fall a long way short, as the details provided in those annual reports were sparse. In most cases, current ODV is given, but all the previous value figures were omitted, making it impossible to study changes in valuations (Hooks, Coy & Davey 2002, p. 509). Another case study was conducted on Sydney Water Corporation, one of the largest water entities in water utilities businesses in Australia, which is engaged in water harvesting, distribution and the provision of wastewater facilities. It operates under the State Owned Corporations Act, which provides water, sewerage and drainage services to over 1.3 million properties in metropolitan Sydney, and the surrounding Illawarra and Blue Mountain areas, with an annual turnover of more than $1.2 billion. Under its earlier name, Sydney Water Board revalued some of its pipes and tunnels in its financial year. This was the first time that it deviated from recording its long-life assets at historical cost. By doing so, Sydney Water Board recorded its largest balance sheet revision ever 92

95 undertaken in a single year in Australia. Water mains, tunnels and canals were revalued and said to represent only 18.5 per cent of the its infrastructure, presumably, calculated with reference to prior book values. Interestingly, the revaluation lifted the book value of these assets from $674.6 million to $3.24 billion an increase of nearly 400 per cent (Walker, Clarke & Dean 2000, p. 13). The following year in witnessed an even larger revaluation, which covered all of the remaining infrastructure assets, except land. This case study found that the impact of these asset revaluations has increased reported depreciation substantially, and reduced reported profit. It inflated total asset value and equity, which is the denominator in the rate of return on assets calculations (Walker, Clarke & Dean 2000, p. 13). In , Sydney Water Corporation reported that it had used the modern engineering equivalent assets (MEERA), which is the DORC valuation basis, to value system assets and produce a downward revaluation of more than $2 billion for those items, and after the upward revaluation of other assets it led to the net downward revaluation of $1.677 billion. The experience with Sydney Water s asset revaluations suggested that its reported data would be contestable. It is unlikely that its financial performance could be correctly evaluated (Walker, Clarke & Dean 2000, p. 17) Definitions of natural monopoly The Oxford Dictionary defines a monopoly as either the exclusive possession or control of the supply of or trade in a commodity or service. The word monopoly originated via Latin from the Greek word monopolion monos means single and polein means sell. For example, Australia Post is in charge of all postal services in Australia. By contrast, a natural monopoly such as a water utility business is a condition which involves the lowest long-run average cost, whereby it is most efficient on cost-technology for production to be served by a single, largest supplier of the entire market for a particular industry. Many academics and economists have attributed the original concept of natural monopoly to the work of John Stuart Mill in his book Principles of Political Economy in He 93

96 used the term concerned natural abilities to refer solely to market failure in utility businesses such as rail, post and electricity. He developed the idea that what is true of labour is also true of capital, and made specific reference to network industries (e.g. electricity, post and rails) as practical monopolies. Mill s description of natural monopolies fits into the modern description, as he claimed that government is partly in control of the business or retains power over it. In doing so, the profits of the business may be obtained from the public, and there is often a legal prohibition against competition in rates of any business regulated by the government. Posner (1969, p. 548) suggested that natural monopoly is a relationship between demand and the technology of supply. Another scholar, Kahn (1971, pp ), described natural monopolies as the inherent tendency to decrease unit cases over an entire range of market. Factors of a natural monopoly consist of large fixed investments, fixed and essentially immovable connections between suppliers and customers, obligation of instantaneous supply, and wide fluctuations in demands for service. Posner also stated that the (telephone) network effects could lead to subadditive costs, and when more customers are connected to the network, cost per customer will increase because there are more subscribers. The average cost per subscriber will increase, but it is still more efficient for a single firm to supply the network service. Similarly, Kahn (1970, pp. 119, 173) noted that both economies of scale and the presence of fixed or sunk costs contribute to destruction of competition within the natural monopoly business, resulting in a single-firm production rather than a small number of firms in the long run. Kahn stressed that economies of scale can be achieved; however, there are related cost-side economic attributes that are potential social costs of duplicated facilities to a single-firm production being less costly, compared with multiple firm production. That is, a combination of economies of scale and sunk costs will allow natural monopoly to emerge in the market. Carlton and Perloff (2004, p. 104) maintained that natural monopoly is a single firm in a market, whereby total production costs would rise when two or more firms have produced instead of one. All four scholars have pointed out that in terms of a firm s cost function, it would be most efficient for a single firm to produce, assuming that costs are lowest based on the same technology and input prices. By adding only one more customer, the company s revenue 94

97 will increase, and the average cost of providing the company s customer base will decrease. As long as the natural monopolist s average cost of serving customers is decreasing, a single, largest firm can efficiently serve the entire customer base. Baumol, together with Bailey, Panzar and Willig (1977, pp ), not only formalised but also extended the current definition of a natural monopoly. They established that a natural monopoly is an industry where multiform production is costlier than production by a monopoly. That is, a single industry can produce output to supply the entire market at a lower per-unit cost compared with two or more firms (subadditivity of the cost function). Baumol also linked the definition of a natural monopoly to the mathematical concept of subadditivity of the cost function. He claimed that the scale economics (are) neither necessary nor sufficient for monopoly to be the least costly of productive organisation. Economies of scale are not a necessary but a sufficient condition for subadditivity. His theory demonstrated that economies of scale on its own do not constitute a barrier to entry. In order for them to work and to deter entry, they must be associated with sunk costs, investments made in long-life physical assets such as those of water utility businesses. Otherwise the values of these assets are considered almost worthless and have no alternative use Foundations of price regulation Regulation is the public economics face of industrial organisations, as it enables governments to explore various ways and interfere with industrial activities. Under complete information, technological efficiency requires a single operating firm. Watts and Zimmerman (1978, pp ; 1990, pp ) developed an accounting theory, which is part of positive accounting theory, called agency or contracting theory. This is where the authority, acting as a consumer agent, commits to setting prices on the basis that it can recoup the long-run costs of efficient supply. In the same way, as described in Diagram 3.1 below, Laffont (1994, pp ), and Loeb and Magat (cited in Pardina, Rapti & Groom, E 2008, p. 2) identified the framework of new economics of regulation as an application of principal-agent methodology, based on contractual relationship set-up 95

98 in which the principal is the state or the regulatory institution, and the agent is the regulated firm (water business). Principal (regulator/ state) Agent (water utility business) Customers Diagram 3.1: Agency theory Efficient supply is the level where the market can prevail, assuming that it is a contestable market. The regulated supplier derives a stream of residual income that depends on the costs it incurs relative to the prices that it would set under a contestable market. The regulator has to balance the legitimate business interests of the owner, the water utility business, to provide service against the rights of access seekers and users for an efficiently priced water service. These competing interests can impact the price of water and the incentive for investment in this essential infrastructure. Price of water must be set correctly, or else it will send incorrect signals to both consumers and investors, resulting in a less than efficient allocation of resources. Several authors including Lapsley (1993, pp ), Vass (1992, pp. 1 8), Whittington (1994, p. 90), Puxty (1997, pp ) and McInnes (2002, pp ) have all maintained that accounting is a central part of the regulatory system, with the creation of a monopoly that gave rise to the challenge of devising a regulatory system to protect consumers. The same concept can be found in economics theory, where Golberg (1976, 96

99 pp ), Williamson (1976, pp ) and Schmalensee (1979, pp ) also maintained that regulation is either an implicit or an explicit contract between the regulatory authority, consumers and supplier(s). Where natural monopoly exists, such as in water businesses, the regulatory goal is to improve the incentives for owners (water utility businesses), so that their behaviour is more closely aligned with that of a competitive market. The key task of the regulator is to balance these interests. Historically, it was not until the 1930s that the notion of what constituted a public utility could be legitimately regulated by state, federal or municipal authorities, via the power delegated to them by their state government. Prior to the 1930s, government price regulation was constitutionally quite narrow; the landmark case was Munn v. Illinois 94 U.S. 113 (1877), where the Court upheld legislation proposed by the National Grange to regulate the rates of railroads owned by grain elevators. The grain elevators and warehouses in Chicago were required to obtain licences and to charge prices which did not exceed levels specified. The important factor in the Court s decision was that the ownership of these facilities constituted a virtual monopoly. The Court declared that the business interest (private property) used for public good needed to be regulated by the government. It was after the Munn case that states were allowed to regulate utility businesses such as railroads; this case was also regarded to be a milestone in the growth of federal government regulation. Bonbright (1961, p. 8) found that the product had to be important or necessary, and the production technology had to have natural monopoly characteristics. Another leading case was Smyth v. Ames 171 U.S. 361 (1898), which was a Supreme Court case in the United States. The case was argued on 5 7 April 1897, and decided on 7 March 1898 by a unanimous vote of nine to zero for the Court. In Smyth v. Ames, the Supreme Court made void a schedule of railroad tariffs, and defined the constitutional limits of governmental power to set railroad and utility rates. The Court held that regulated industries were constitutionally entitled to earn a fair return on the fair value of the business. Under the fair value rule, a governmental authority was not only required 97

100 to determine a rate base, which was the present value of the business's assets, but was also allowed to charge rates sufficient to earn a normal return on that value. Three approaches for asset base determination were also identified from the decisions of this Court, which are the historical cost, market (fair) value and replacement cost. The Smyth v. Ames case was decided as the Court's protection of the free market economy in the late 19 th century. It was subjected to criticism that the fair value rule was impractical because of complex administrative proceedings required to determine current value of utility assets as the rate base. The problem of circularity was thus created. That is, it was illogical for a utility's value to be determined by its rates, as it is impossible to set rates according to a business s value, since that value cannot be known until the rates are determined. The decision in Smyth v. Ames was adhered, and set the constitutional limits of rate regulation for over 46 years. This notion of fair value remained the law of the land until it was overruled in Federal Power Commission v. Hope Natural Gas Co. 320 U.S. 591 (1944). By 1944, the United States Supreme Court had realised that the problem of circularity, (i.e. fair value) is the end product of the process of rate-making, and not the starting point. At the heart of this problem is that rates cannot be made to depend upon fair value when the value of the going business depends on earnings under whatever rates may be anticipated. As the deprival value depends on revenue expectations; it cannot at the same time be the basis for setting revenues. Put differently, the original intention was that the rate base should be used to determine asset value, and not the other way around. Hope s case was described by Bonbright (1948, p. 465) as: One of the most important economics pronouncements in the history of American Law. Unless the Court reverses itself, no longer will it impose upon legislatures or commissions, state or federal, the severe restrictions upon their powers to fix rates that it previously imposed under its doctrines in Smyth vs. Ames. The rule of 98

101 reasonable return on fair value may still be retained by states that choose to retain it. But it has ceased to be law of the land. Following the Hope decision, there was no specific asset valuation methodology for utility businesses regulatory assets. It not only signalled the end of the Court s role in settling disputes between the regulated entities and the regulators, but also put an end to the use of fair value as the appropriate asset valuation methodology. The important ongoing implication from this case is that the court should not be involved as long as utility businesses are able to operate successfully and attract capital. In practice, the decision as to which asset valuation methodology needs to be used is now left to the regulatory commissions. Even today, the United States Supreme Court s old judicial precedent decision set the basis for subsequent utility regulation in the United States, and has been adopted by regulators in the United Kingdom and Australia. Similar principles were also confirmed in the Supreme Court of Canada in British Columbia Electric Railway Co. v. Public Utilities Commission, [1960] S.C.R Effects of rate regulation and price on utility businesses The benefits of a regulatory framework include lower network service costs, improvements in service quality, investment to expand the network to support changes in supply and demand for network services, and development of efficient network platforms to support robust competitive wholesale and retail markets (Joskow 2008, p. 548). Traditionally, rate-of-return regulation has been used to set prices for utility businesses, as it incorporates pricing flexibility elements, wherein it allows utility businesses to charge preferred prices that it sees fit within the total MAR cap. The business is given a review period of three to five years to recover relevant costs, and is also allowed to recover its asset value through depreciation charges (return of capital), and earn a return on the outstanding balance. 99

102 In theory, pricing principles set prices to recover fully the most efficient costs of service provision, including the significant impact of consumption behaviour and investment activity. This is the reason why capital charges are said to allow a return of and on the asset base. That is, the regulator would be expected to increase prices whenever the company s revenue requirements rise under rate-of-return regulation. Price control is intended to last for a defined regulatory period, between three and five years, regardless of what happens to the water utility business s costs. However, it is possible for water utility businesses, being natural monopolies, to meet targets simply by increasing prices and revenues, or by reducing quality of service, rather than by seeking the most efficient methods of production (Temple-Heald 1991, p. 12). Most academic research on regulation and effects on pricing have focused on the telecommunications industry. Ter-Martirosyan (2003, p. 2), and Currier and Jackson (2008, p. 261) claimed that within the last 20 years, rate-of-return regulation has predominantly been replaced with price-cap regulation, as the latter generates more efficient pricing structures and strong incentive for cost reduction. In fact, the principal innovation in regulatory policy in the last 20 years has been the application of price-cap regulation. All 50 states in the United States, as well as many other countries around the world, have implemented price-cap regulations. Research into the effect of rate regulation on utility businesses and prices not only varies widely, but is also limited. While there is extensive literature on incentive regulation (price-cap), there is very limited guidance for its practical application in real-world circumstances. Averch and Johnson (1962, pp ) developed a theory of monopoly business, seeking to maximise profit and subject to a constraint on its rate of return. They concluded that the regulated business operates inefficiently because social cost is not minimised by the output the business selects. They disclosed the behaviour of the business where misallocation of economic resources exists from the regulator s use of the rate-of-return constraint for price control. They claimed that it is difficult to determine the correct rate of return, as there is a poor incentive for cost reduction, and the regulatory 100

103 practices provide an incentive for businesses to operate even at a loss, as certain activities of a business are considered to be public knowledge and can be subsidised. Tardiff and Taylor (1993, cited in Kridel, Sappington & Weisman, p. 301), in contrast, found virtually no statistical evidence that regulation can enhance infrastructural investment. In contrast again, Greenstein, McMaster and Spiller (1995, cited in Kridel, Sappington & Weisman, p. 301) found that price-cap regulation leads to significant investment in telecommunications infrastructure. Crandall and Waverman (1995), in their book Talk is cheap, revealed that under price-cap regulation, residential and business telephone prices were the lowest compared with other forms of incentive regulations. During the 1990s in Latin America, Rudnick and Zolezzi (2001, pp ) examined changes in several dimensions of productivity in electricity sectors. Their studies found significant improvements in productivity indicators. In the United States, Ai and Sappington (2002, pp ) provided the most comprehensive study on the impact of state incentive regulation mechanism on network modernisation, aggregate demand, revenue, cost, profit and local service rates applied to local telephone companies from 1986 to Evidence of lower operating costs, lower rates for business customers, and increased network modernisation were identified by them under various forms of incentive regulation. Most importantly, they examined and discovered that incentive regulation contributes to cost reductions and network modernisation. Currier and Jackson (2008, p. 262) confirmed that the application of price-cap regulation will increase productivity and consumer welfare. In general, price caps have proven far more superior incentives, because they combine both incentives for cost reduction and efficient pricing, which lead to Pareto improvements compared with rate-of-return regulation (Vogelsang 2002, p. 5). 101

104 3.13 Summary Normative theories of accounting that prescribe that assets should be valued using specific asset valuation techniques have been considered in this chapter. Broadly, the variety of asset valuation techniques have been discussed, which is the HCA, the CCA, the NRV accounting, the NPV accounting and the FVA. Other varieties which are applicable to utility businesses, such as the ODV and the DORC techniques, were also discussed. In practice and as stated in paragraph 100 of the International and Australian Accounting Conceptual Framework Framework of the Preparation and Presentation of Financial Statements, HCA is the dominant framework for recognition and measurement. However, this foundation is slowly being replaced by FVA. Clearly no asset valuation method is perfect, and neither is entirely satisfactory. Within competitive markets, the business s asset valuations are not as important or complex as they are for government trading enterprises, such as water utility businesses, which have the potential to exert monopoly power; therefore, their efficiency and profits are of interest. Profit should be reasonable to the amount of assets employed. All of the asset valuation techniques have serious accounting implications, as many of these assets have little, if any, resale value or alternative use (sunk cost). In principle, HCA provides a fair and reasonable return to service providers. On one hand, it can guarantee capital maintenance in that there is certainty about recovery of investment costs. It is potentially the most objective and lowest cost asset valuation method. On the other hand, it constrains price increases to consumers, and therefore cannot be considered economically efficient. Its foundation as the dominant framework for recognition and measurement of assets has therefore been replaced by FVA. The discussion in this chapter has revealed that the deprival value method is forwardlooking; it eliminates the problems associated with inflation, and includes technological advancements unlike the traditional HCA. The deprival value method reflects the EV of capital equipment used, as its underlying assumption is that the assets should be valued in terms of the economic loss suffered if deprived of the use of the asset. The loss can either be measured on the basis of the cost of replacing the asset with a modern equivalent or, if this is not economical, on the basis of future income stream foregone. However, this 102

105 method can unnecessarily inflate the rate base for depreciation charges, leading to higher prices for consumers and windfall profits for the owners. Nevertheless, this method is more consistent with modern economics/accounting theory, even though it is not perfect. Unfortunately, there is no rigorous basis to determine the correct valuation that is inbetween. The first asset valuation survey result concluded that progress has been made for better appropriateness and consistency in accounting for local authority asset valuations. The second survey revealed that asset valuation using the DORC method is not consistent in deriving an appropriate RAB figure for financial reporting purposes. These inconsistencies existed due to the main elements of the DRC method, ranging from the component level used in the valuation, the application of approaches used to derive the replacement cost, the optimised asset figures, the assets remaining useful lives and the depreciation rates used. The third survey concluded that the disclosures on the ODV fall a long way short because under the ODV, details provided in the annual reports are sparse. In many cases the current optimised value is given; however, any previous figures are omitted, making it impossible to compare changes in asset valuations from one financial year to another. The case study found that when assets are optimised, asset revaluations result in substantial increments in reported deprecation, inflated total asset values and reduced reported profit. The original concept of natural monopoly was the work of an economist, John Stuart Mill, in his book Principles of Political Economy in The formalised and current definitions of natural monopoly are the work of Baumol, together with Bailey, Panzar and Willig in Their theory demonstrates that economies of scale on its own do not constitute a barrier to entry. For economies of scale to work and to deter entry, it must be associated with sunk costs. Several scholars have identified the framework of the new economies of regulation as an application of principal-agent methodology, based on the contractual relationship set-up in which the principal is the state or the regulatory institution, and the agent is the water business. The regulator needs to balance the legitimate business interests of the owner, the water business, to provide service against the rights of the consumers to an efficiently 103

106 priced water service. The price of water must be correctly priced for the economy as a whole. Regulation is an implicit or explicit contract between the regulatory authority, consumers and the regulated supplier(s). The key task of the regulator is to balance the interest of the owners (water businesses) so that their behaviour is more closely aligned with those that would occur in a competitive market. Research into the effects of rate regulation and prices in utility businesses not only varies widely, but is also limited. There is very limited guidance for its practical application in real-world scenario. The following chapter provides an overview of the industry governance, structure and the broad area of ownership for urban water services in major Australian cities. 104

107 Chapter Four: The Urban Water Industry in Major Australian Cities 4.1 Introduction Chapter Two presented the main characteristic of water as a natural monopoly where a single, largest supplier in the industry rules the market. In water business, the supplier has an overwhelming cost advantage over other actual and potential competitors. Therefore, it is far more economical for one business with similar technology and consumer demand to serve the relevant market than for several businesses to do so. Water businesses are considered long-term, capital-intensive type with minimum decline in their book value. However, since economies of scale in relation to the size of water market are often created, there are high barriers to entry and competition is often not possible. Chapter Three then discussed a general overview of asset valuation from an academic point of view. The purpose of this chapter was to provide an overview of the industry governance and structure, and the broad area of ownership for urban water services in all Australian states New South Wales, Victoria, Queensland, South Australia, Western Australia and Tasmania. Urban water means both water and wastewater services, such as water provision and wastewater disposal for private individuals and businesses, as well as water services for environmental uses and stormwater management for public services. The urban water industry is mainly involved in two main sectors, which is the supply of reticulated potable water, and collection, treatment and disposal of wastewater. Governments are particularly interested in water more than other natural resources, because they need to ensure that water resources are used and provided to maximise society wellbeing. In the absence of a competitive market, where demand and supply determine price, governments need to be actively involved to ensure that water is both allocated and priced efficiently, and that water services are provided at maximum value and minimum cost. There are many similarities as well as significant differences between the organisation and the operation of urban water and wastewater sectors in Australia s major cities, and these will be discussed in detail in this chapter. 105

108 4.2 New South Wales The industry In New South Wales, the IPART looks after regulation of the electricity, gas, water and transport industries. There are two major bulk water storage operators in New South Wales, that is, the Sydney Catchment Authority (provides bulk water storage for Sydney) and the State Water Corporation (operates bulk storages in regional and rural areas). The water utilities and local councils are responsible for treating the water and distributing it beyond river systems. Over half a million people in six local government areas, including Newcastle, Lake Macquarie, Maitland, Cessnock, Port Stephens, Dungog and small parts of Singleton receive water from Hunter Water. A number of other bulk storages throughout the state are also owned and operated by Hunter Water and local councils. Hunter Water in Newcastle, and the local councils distributes and provides water retail services for the remaining urban areas. The National Water Services Association (2008, p. 17) recorded that there are 106 non-metropolitan local water utilities, 27 of which serve over connected properties, serving a total population of 6.6 million, including 1.8 million in non-metropolitan NSW. Governance of urban pricing Diagram 4.1 below shows that in New South Wales, water management responsibilities rest with various states, regional and local organisations (National Water Commission 2009). 106

109 Diagram 4.1: Management of water in New South Wales Local Regional State Water pricing and economic regulation Water pricing and economic regulation Water planning and management Water markets Water supply and services Water supply and services Water quality Source: management (National Water Commission 2009). Local water utilities Irrigation companies NRM bodies Ministers departments Economic regulator Major water utilities (National Water Commission 2009) Water supply Currently, Sydney s potable water supply is sourced from 11 major dams. Warragamba Dam is the largest dam. There are several dams in the catchments of the Upper Nepean, Woronora, Blue Mountains and Shoalhaven. Marsden Jacob Associates (2006, pp. 8 9) stated that during dry periods, Sydney s dams can store around GL of water at full capacity; able to provide for four years under zero inflow conditions. 107

110 Supply demand balance In Sydney around 420 litres per person per day was used before implementation of water restrictions in Of that 256 litres was used for residential purposes. WSAA (2005) indicated that in , after the introduction of Level 2 Water Restrictions, residential water use per capita fell by 17 per cent, and commercial and industrial water use fell by 9 per cent (Marsden Jacob Associates 2006, p. 11). Planned demand management strategies need to be put in place to cater for the growth in population as Sydney s population is expected to grow to around 5.3 million by Marsden Jacob Associates (2006, p. 11) predicted that water use would be expected to grow over 800 GL per annum over the same period. By 2015, water supply availability could reduce by approximately 80 GL per annum when the New South Wales Government have the information needed to decide on the environment flows to be provided to the Hawkesbury River from the Warragamba Dam. Water and sewerage reform Since 2006 there have been major changes at the national level, including the transfer of some state water management powers from the Murray-Darling Basin to the Commonwealth. The Murray-Darling Basin extends across four states: Queensland, New South Wales, Victoria and South Australia. A large proportion of it passes through about 57 per cent of New South Wales s land area, and some 51 per cent of its surface water extractions. All of inland New South Wales, with the exception of the far north-west corner of the state, lies within the Murray-Darling Basin. The majority of New South Wales water use and licence holders are within this Basin, and any changes to Murray- Darling Basin water management will significantly impact this state s water management activities (New South Wales Office of Water 2009, p. 8). The signing of an inter-governmental agreement on the Murray-Darling Basin reforms in July 2008 resulted in significant changes, such as: 108

111 The establishment of the Murray-Darling Basin Authority to develop a Strategic Basin Plan by 2011, which sets new (and probably lower) water extraction limits for each catchment in the Basin. The involvement of the Australian Competition and Consumer Commission (ACCC) in developing water market trading and water charging rules. The expansion of water information functions of the Bureau of Meteorology. The entry of the Commonwealth into the Murray-Darling Basin as a major purchaser and holder of water licences (New South Wales Office of Water 2009, p. 8). 4.3 Victoria The industry Victoria s water businesses provide water and wastewater services to customers of 19 regions. In metropolitan Melbourne these services are provided by four providers: Melbourne Water Corporation (one bulk water company), and the four water retailers City West Water (includes the central business district and western Melbourne); South East Water (includes south eastern Melbourne, parts of the Dandenong Ranges and Mornington Peninsula); Yarra Valley Water (includes eastern and north eastern Melbourne, and the Yarra Valley); and Western Water (includes Sunbury, Melton, Macedon Ranges, Gisborne, Woodend, Romsey, Lancefield and Bacchus Marsh). These five state-owned corporations were established when Melbourne Water was split up in 1995 (Engineers Australia 2005, p. 37). The list of the 19 Victorian state-owned water businesses is set out in Diagram 4.2 below. 109

112 Melbourne Melbourne Water South East Water Yarra Valley Water City West Water Western Water East Gippsland Water East Gippsland Water South Gippsland Water Westernport Water North Lower Murray Water North-East Water Goulburn-Murray Water Coliban Water Goulburn Valley Water West Grampians Wimmera Mallee Water Wannon Water Barwon Water Central Highlands Water Southern Rural Water Diagram 4.2: 19 state-owned water businesses in Victoria These 19 water businesses report to the Victorian Government, and each supplies water and/or sewerage services to customers within its specified geographic region within the metropolitan or urban service area, as set out in Figure 4.1 above. Grampians Wimmera Mallee Water and Lower Murray Water are the result of amalgamations of both urban and rural businesses from 1 July The Melbourne Water Corporation manages supply catchments, reservoirs and major distribution systems for metropolitan Melbourne, and is responsible for the harvesting, treatment and transfer of water to the four Melbourne retail water providers (Engineers Australia 2010, p. 66). The structure of the Melbourne Water Corporation is similar to that of Sydney, as both provide wholesale water to the retailers and are responsible for catchment management. By contrast, the Melbourne Water Corporation is also responsible for both the operation of major sewerage treatment and the drainage systems. In Sydney, these fall under the Sydney Catchment Authority. Governance of urban pricing Diagram 4.3 below shows that in Victoria, water management responsibilities rest with various state and regional organisations (National Water Commission 2009). 110

113 Diagram 4.3: Management of water in Victoria Local Regional State Water pricing and economic regulation Water planning and management Water markets Water supply and services Water quality management NRM bodies Ministers departments Economic regulator Urban and rural water (National Water Commission 2009) Urban wholesale water providers Melbourne Water, Goulburn-Murray Water, Grampians Wimmera Mallee Water and Southern Rural Water pass on bulk water charges to urban retail water providers. These charges are in line with those determined by the regulator, the ESC. Urban retail water providers In Melbourne, urban water providers are there are four metropolitan water businesses, that is, City West, South East, Yarra Valley and Western Water. Retail water and wastewater charges are pass on to urban water customers by the 12 regional urban retail water providers, that is Barwon, Central Highlands, Coliban, East Gippsland, Gippsland, Goulburn Valley, Grampians Wimmera Mallee, Lower Murray, North-East, South 111

114 Gippsland, Wannon, and Westernport. These charges are in line with those determined by the ESC. Water availability In Victoria, the ESC regulates the prices and service standards of water providers throughout the state, and significant restructuring has resulted in the separation of Melbourne Water as the bulk supplier (wholesaler) and four retail companies, which supply different regions in greater Melbourne. As a result of a series of amalgamations of smaller local government and independent water bodies, the remainder of the state of Victoria is served by a number of regional water service providers. These amalgamations have given these regional utilities a clear focus on water services, and substantially greater scale of service provision with commensurate gains in operations capability, efficiency and skill base (Langford & Piccinin 2004, p. 72; ACIL Tasman 2005, p. 31). This is in contrast with New South Wales, where the state government owns water service providers for the cities of Sydney and Newcastle, while local governments are the owners elsewhere in NSW. The New South Wales structure is all vertically integrated with the exception of Sydney, where Sydney Water is responsible for water treatment, retailing and wastewater services, and Sydney Catchment Authority is responsible for bulk water provision (Langford & Piccinin 2004, p. 72; ACIL Tasman 2005, p. 31). On the other hand, in Victoria the four retail water and sewerage companies operate according to their allocated geographic areas as follows: City West Water, serving approximately people, including the central business district and western Melbourne South East Water, serving approximately 1.4 million people, including south eastern Melbourne, parts of the Dandenong Ranges, and the Mornington Peninsula Yarra Valley Water, serving approximately 1.5 million people, including eastern and north eastern Melbourne, and the Yarra Valley. 112

115 Western Water, serving approximately 158,300 people, including North West of Melbourne (Melton, Bacchus Marsh, Lancefield and Sunbury). These four companies are state-owned and operate under the Corporations Act 2001, following commercial principles. They are responsible for retail water supply to customers and sewerage collection and limited sewerage treatment, and each company has its own customer base. Even though they do not compete directly for each other s customers, they compete under the ESC s monitoring regime by comparison of services (Engineers Australia 2005, p. 38). Supply demand balance At present, Melbourne s water storages are 34 per cent full. Most of Melbourne s water comes from its uninhabited catchments high up in the Yarra Ranges (Melbourne Water, 2009). The majority of water used in Melbourne today is sourced from rivers and reservoirs. Table 4.1: Melbourne s water sources Water source Rivers and reservoirs Recycled water Groundwater Rainwater and stormwater Volume used 435 GL in GL (average from ) 46 GL (most recycled at sewerage treatment plants) Up to 33 GL Less than 1 GL (Marsden Jacob Associates 2006, p. 44) As shown in Map 4.1 below, Melbourne has nine major reservoirs that currently supply its water, excluding Tarago. The reservoirs have a total storage capacity of GL, the largest being the Thomson Reservoir which holds almost 60 per cent (1 068 GL) of the 113

116 total system storage capacity. Water can be moved between reservoirs, mostly from east to west through use of gravity. Approximately 75 per cent of Melbourne water passes through either the Silvan Reservoir which is 40 km east of Victoria, or the Cardinia Reservoir located in Emerald-Clematis-Dewhurst in the south eastern suburbs of Melbourne (Engineers Australia 2010, p. 66). Map 4.1: Melbourne s major reservoirs (Engineers Australia 2010, p. 66) According to Marsden Jacob Associates (2006, p. 45), water is stored and then delivered to metropolitan retail water companies, Western Water and regional water business Gippsland Water. Water is also released from the Thomson Dam for Southern Rural Water s irrigators. In reference to the supply of water, in a typical year Victoria receives about GL as rainfall. This can either be consumed by plants or evaporation only 16 per cent ( GL) flows into streams, and 1 per cent filters through to recharge groundwater aquifers. 114

117 Of the water which enters the rivers, 27 per cent is extracted for consumptive use, with some 77 per cent of this extracted water used for irrigation, 4 per cent for domestic and livestock purposes on rural properties, 10 per cent for Melbourne residents and providers, and 9 per cent for regional towns and providers. About 3 per cent of the water is used by brown coal power generators in the Latrobe Valley, as identified in Figure 4.1 below. Figure 4.2: Total surface water Victoria per cent of use and Melbourne per cent of use Total surface water 2004/05 Water for rivers Water used Victoria % of use Irrigation Rural, domestic & stock Melbourne % of use Residential Non-revenue Industry 115

118 (Engineers Australia 2010, p. 64) Water and sewerage reform In the last decade, Victoria has experienced drought created along with the water crisis in the last five years. A 30 per cent reduction in average rainfall, persistent declines in water storages, ongoing drought and population growth have forced the Victorian Government to implement water restrictions, conservation measures and supply augmentation projects. The water crisis has accelerated the need to manage all water resources (water supply such as rainfall, inflows, groundwater, wastewater, recycled water and stormwater) in an integrated manner (Engineers Australia 2010, p. 61). This means that to deliver water for economic, social and environmental benefits, savings in water and wastewater treatment and ecological restoration should occur. This can be achieved by using different water types such as recycled water for their highest value use, without becoming reliant on one source (Engineers Australia 2010, p. 61). Victoria s water strategy can be found in its 2004 Victorian Government White Paper Securing Our Water Future Together. This document outlines the state s action plan to secure water for all interests over the next 50 years. It describes actions to address the following priority areas: To improve the framework for allocating water resources by recognising the needs of all water users and the environment, and setting up a process for regional water planning and review. To restore stressed rivers and aquifers by creating a legal water entitlement for the environment, and improving planning and management of river health. To promote smarter use of irrigated water by separating water entitlements and land ownership rights, and promoting investments in new, more efficient irrigation practices. To encourage the smarter use of urban water via a range of investment and pricing measures, to increase water conservation and recycling. 116

119 To make the water sector more efficient, accountable and innovative by improving the institutional governance arrangements (Engineers Australia 2010, p. 61; Victorian Government 2010). Following the reform in 2007, an update was produced and this plan is now called Our Water Our Future The Next Stage of the Government s Water Plan, or the Victorian Water Plan. It was produced in response to unprecedented low inflows into water storages in 2006, increased demand due to higher than expected growth in the population and economy, and projected climate change impacts (Engineers Australia 2010, p. 62; Victorian Government 2010). This plan cost $4.9 billion and it has identified the need for urgent, large-scale supplyside augmentations for the Melbourne water supply system. The key initiatives are to: build a desalination plant in Wonthaggi region (estimated to supply up to 150 billion litres of water a year) save water by upgrading irrigation channels in the Food Bowl region of northern Victoria expand the Water Grid to pipe water around the state, including the new Sugarloaf Pipeline connecting Melbourne to the Goulburn River extend water conservation and recycling programs, including upgrading the Eastern Treatment Plant. The most significant of all the measures to address Victoria s water crisis is construction of the desalination plant. The plant enables water reservoirs to refill and will possibly allow for water restrictions to be removed over the next few years. As of 1 December 2012, Stage 1 Water Restrictions were lifted, and if no further major policy changes occur, the growing population and economy will eventually result in demand exceeding supply. Following the current suite of augmentation, water storage levels are again forecast to drop to a level requiring Stage 1 Water Restrictions to be introduced by 2036 (Engineers Australia 2010, p. 62; Victorian Government 2010). 117

120 4.4 Queensland The industry In Brisbane, the Brisbane City Council is responsible for its major water services. Bulk water supply is provided in a number of regions by corporate entities of the Queensland Government, including the South East Queensland Water Corporation Limited (SEQ Water), SunWater, Gold Coast Water (GCW), Redlands Water & Waste (RWW), Gladstone Area Water Board (GAWB), and Fitzroy River Water (FRW). SEQ Water is a major supplier of untreated water in bulk to local governments and industries in the South East Queensland region. SEQ owns Wivenhoe, Somerset and North Pine dams. SEQ Water is a public company. 20 per cent ownership is owned by the Queensland Government, 45 per cent by Brisbane City Council, and eleven other local governments in South East Queensland own 35 per cent of SEQ Water. According to Marsden Jacob Associates 2006, (p. 58), SEQ Water provides services to 18 local government areas, including Beaudesert, Boonah, Brisbane, Caboolture, Caloundra, Esk, Gatton, Gold Coast, Ipswich, Kilcoy, Laidley, Logan, Maroochy, Noosa, Pine Rivers, Redcliffe, Redland and Toowoomba. SunWater is another Queensland Government-owned water corporation, and it operates a regional network of water supply infrastructure throughout regional Queensland. SunWater supports irrigated agriculture, mining, power generation, and industrial and urban development. SunWater's water storage and distribution infrastructure includes 26 major dams, 81 weirs and barrages, 72 major pumping stations, and more than kilometres of pipelines and open channels. SunWater supplies approximately 40 per cent of the water used commercially in Queensland (Marsden Jacob Associates 2006, p. 58). The GAWB operates as a commercialised statutory authority, with responsibility for water management and bulk supplies. It owns and operates Awoonga Dam on the Boyne River in Calliope Shire, along with a network of delivery pipelines, water treatment plants and other bulk water distribution infrastructure in Gladstone City and Calliope Shire in Central Queensland (Marsden Jacob Associates 2006, p. 58). 118

121 FRW supplies bulk water to Livingstone and Fitzroy Shires, and water and wastewater services to Rockhampton residents. It is a commercialised business unit of the Rockhampton City Council (Marsden Jacob Associates 2006, p. 58). Water is supplied to households and businesses in towns and cities of Queensland by 125 local governments. According to Marsden Jacob Associates (2006, p. 59), many of the councils operate standalone water supply systems, while others purchase water from one of the bulk water service providers. Councils typically operate the delivery network and, in many cases, water treatment infrastructure. Some of the larger council operations include: Brisbane Water (BW), a commercialised business unit of the Brisbane City Council, providing infrastructure to treat and deliver water purchased from SEQ Water GCW, a directorate of the Gold Coast City Council the northern part of the Gold Coast is supplied by SEQ Water, while the remainder of the region mainly relies on supplies from Hinze Dam and Little Nerang Dam, which are owned by Gold Coast City Council RWW, a commercial business unit of Redland Shire Council, where water is sourced from Leslie Harrison Dam on Tingalpa Creek and North Stradbroke Island. In South East Queensland, as part of the Queensland Government s reform of water supply arrangements, the water businesses of Gold Coast City Council, Logan City Council and Redland City Council transferred to and now known as Allconnex Water (Essential Services Commission of South Australia 2012, p. 4). A planning system is designed by the Queensland Government to oversee and facilitate sufficient supply through catchment planning, providing allocations of water for consumptive use and environmental requirements. The Queensland Government is responsible for much of the infrastructure planning that lies with the actual service providers (e.g. SunWater, SEQ Water and BW). Storage and major water distribution infrastructure is owned by a mix of SEQ Water and local government service providers, while reticulation infrastructure is generally owned by the local government infrastructure providers (Marsden Jacob Associates 2006, p. 59). 119

122 The QCA oversees water pricing and practices of declared government monopolies, or simply monitors the prices charged by them when directed by ministers. So far there are only three investigations which have been referred to the QCA: the Burdekin Haughton Water Supply Scheme, and two on the GAWB (Marsden Jacob Associates 2006, p. 59). Governance of urban pricing In Queensland, water management responsibilities rest with various state organisations (National Water Commission 2009). Figure 4.3: Management of water in Queensland Local Regional State Water pricing and economic regulation Water planning and management Water markets Water markets Water supply and services Water quality management Local councils Water supply schemes (National Water Commission 2009) Water authorities 120 Ministers departments

123 Water supply demand balance In South East Queensland, SEQ Water is a major supplier of untreated water. Traditionally, a degree of separation exists between the responsibilities for water supply planning, managing bulk water infrastructure and managing the reticulation of services to customers. Marsden Jacob Associates (2006, p. 60) reported that South East Queensland experienced its worst drought in over 100 years from April 2001 to April The exacerbated drought conditions highlighted the apparent failure in coordination of resource and infrastructure in South East Queensland in the previous months. The Queensland Government in conjunction with local governments is developing a strategy to improve the coordination of water management across the region. Examples are the establishment of the South East Queensland Regional Water Supply Strategy and the Queensland Water Commission. The combined capacity of dams in the region has fallen below 30 per cent, and without significant rainfall it is expected to fall even further. Most of South East Queensland s local governments are now on Level 3 Water Restrictions, which includes a ban of garden watering with hose pipes or sprinkler systems. Marsden Jacob Associates (2006, p. 60) recommended that more stringent restrictions are likely to be imposed in the coming months. Water and sewerage reform To amplify drought conditions, South East Queensland, which includes Brisbane and Gold Coast areas in particular, is also Australia s fastest growing metropolitan region, and this area is predicted to continue to grow strongly from its 2006 population of 2.8 million to a 2026 population of 3.7 million. This growth will place additional strain on existing water supplies, and an extensive drought response strategy (DRS) will need to be adopted in the region (Marsden Jacob Associates 2006, p. 61). 121

124 The DRS is a three-tier approach to reduce water usage, including the implementation of water restrictions from May 2005, a widespread marketing campaign targeting water savings, and fast tracking or bringing forward the implementation of a number of longterm demand management and water saving programs (e.g. subsidy schemes for retro-fit of water-efficient appliances, rainwater tanks, home water efficiency audits and leakage reduction programs). A strategy has also been implemented to develop additional supplies, such as the Western Corridor Recycling Scheme, Tugun Desalination Plant and bore water scheme (Marsden Jacob Associates 2006, p. 61). The major water company in Queensland, SEQ Water, is not only responsible for constructing, managing and operating water-related infrastructure within its region, but also plays a key role in infrastructure planning. The water companies are the key contributors to the relevant state- or region-based planning documents. South East Water, SunWater and the local government water entities contribute to the regional water supply strategies in their parts of Queensland. Within the broader planning frameworks overseen by the Queensland Government, these water companies have developed their own strategic documents to plan for meeting future demand, such as the South Australia Water Strategic Plan (National Water Commission 2005, p. 23). 4.5 South Australia The industry In Adelaide, the South Australia Water Corporation (SA Water) is responsible for providing water, wastewater and related services to 1.4 million customers in both metropolitan and country areas in South Australia. It is the main bulk water supplier for the entire state, and is a wholly owned business enterprise of the South Australian Government. South Australia is an example of a vertically-integrated supplier (undertaking both bulk and distribution/retail functions) to most parts of their respective states (National Water Commission 2005, p. 27). 122

125 Marsden Jacob Associates (2006, p. 73) maintained that in 1995, SA Water had allowed the operation and maintenance of water and wastewater services in Adelaide metropolitan area (including the delivery of capital works for rehabilitation and augmentation) to be outsourced to a privately-owned company, United Water International Pty Ltd (United Water). It was a 15-year, long-term contract and was a consortium between three private sector companies: Veolia Water, Thames Water and Haliburton KRB. This was the largest water outsourcing contract in Australia, and it remains unique in its current form as the concept of private sector involvement in provision of water and wastewater services, which was relatively new to Australia in The main focus was on provision of services rather than development of infrastructure. Significant efficiency gains, performance improvements and risk transfer are the key aims to achieve while retaining ownership and investment control (Marsden Jacob Associates 2006, p. 73). Marsden Jacob Associates (2006, p. 73) claimed that an estimated 20 per cent saving of cost reduction objective had been achieved, as compared to SA Water s historical costs. It is a saving in excess of $160 million over the life of the contract. SA Water remains the asset owner and maintains control of all asset investment decisions for rehabilitation, renewal and infrastructure augmentation, and it continues to provide services in rural areas and have responsibility for bulk supply. SA Water remains an informed purchaser and is able to benchmark its country operations it retains all customer billing services and customer service standards decisions. Governance of urban water pricing In South Australia, the water management responsibilities relate to various states, regional and local organisations (National Water Commission 2009). 123

126 Figure 4.4: Management of water in South Australia Local Regional State Water pricing and economic regulation Water pricing and economic regulation Water planning and management Water markets Water supply And services Water quality management Water quality management Private irrigation trusts NRM bodies Ministers departments Major water utility (National Water Commission 2009) Water supply South Australia has a reliable urban water supply. Adelaide has access to a diversified water supply, with Adelaide Hills' reservoirs being supplemented by pumping from the Murray River. South Australia s extraction from the Murray River for urban water supply is considered small, and in a normal year total South Australian urban extractions are about 1.5 per cent of total extractions from the Murray-Darling Basin, while those for Adelaide are about 1 per cent (South Australian Government 2009, p. 7). 124

127 In the years of normal rainfall, Mt Lofty Ranges reservoirs are the source of about 60 per cent of Adelaide s water supply, with the remainder being sourced from the Murray River. However, during drought years, the Murray River is the primary water source of up to 90 per cent of Adelaide s water supply (South Australian Government 2009, p. 7). Marsden Jacob Associates (2006, p. 73) found that compared with the approach of other major Australian cities that have built water storages capable of meeting three to four years demand, SA Water does not have large storage reservoirs. For instance, the total capacity of the storages in the Mt Lofty Ranges is equal to less than a year s demand. The current level of storage is estimated to be equivalent to that required to reliably service a population of around 30 per cent the size of Adelaide. Extensive pipelines from the Murray River provide a second water source and promote water security in South Australia. South Australia s current water consumption is approximately ML. The physical infrastructure includes six major water treatment plants, kilometres of water mains, and 52 pumping stations (Abbott & Cohen 2009, p. 10). Water and sewerage reform The South Australian Government took steps to improve water security beyond those taken in response to drought conditions, resulting in substantial investment in critical new water supply infrastructure planned over the next few years from For example, the Adelaide Desalination Plant (ADP) was commissioned one year earlier than first anticipated; water was anticipated to be used from it in A further 30 GL of temporary water allocations from other Murray River users were purchased by the South Australian Government to ensure that South Australia s water needs are able to be supplied in the short term, regardless of the drought (Government of South Australia 2009, pp. i, 15 & 35). These major investments needed to be funded through water charges, and were a major influence on the South Australia Government s water pricing decision, 125

128 culminating in a 17.9 per cent rise in average water pricing that year. Metropolitan wastewater charges remained constant in real terms, while regional wastewater charges increased by 0.5 per cent in real terms, to redress the lower average wastewater bills in regional areas as compared with the metropolitan area (Government of South Australia 2009, pp. i, 15 & 35). The most substantial in Australia is the Adelaide s water recycling program, representing almost 21 per cent of total wastewater collected in Recycled water is mainly used for irrigation rather than as a substitution of potable water. However, it does not typically improve the supply of water to the city itself. The Water Proofing Adelaide Strategy outlines plans to increase water recycling by 16 GL per annum, which is 16 per cent of current wastewater collected. There is also a plan to develop large-scale stormwater reuse for a further 11 GL per annum by 2025 (Marsden Jacob Associates 2006, p. 84). 4.6 Western Australia The industry Western Australian water services are provided for 1.8 million customers across the state. These customers are provided with a mixture of potable and non-potable water, and sewerage and drainage services by a number of organisations. Western Australia s major urban water utilities service providers are Western Australia Water Corporation, Aqwest- Bunbury Water Board (AQWEST), and Busselton Water Board (BWB). Water Corporation supplies water and wastewater services on a state-wide basis, while AQWEST and BWB supply potable water to their respective regional centres (Government of Western Australia 2007, p. 9). In 1996, the Western Australia Water Authority was reconstituted as a government/ stateowned statutory corporation. The corporation was established to provide water, wastewater and stormwater services to a population of around 1.5 million people across the state (urban and regional areas) (Marsden Jacob Associates 1999, p. 86). 126

129 95 per cent of both wholesale and retail water services are provided by the Water Corporation to all Western Australian cities and towns, with the exception of Bunbury (provided by AQWEST) and Busselton (provided by BWB). The corporation also provides wastewater collection and disposal and stormwater services across the entire state. Local government provided wastewater services in a number of rural and regional towns (Marsden Jacob Associates 1999, p. 85). In Western Australia, the Department of Water is responsible for gathering water resource information, issuing licences, regulating water use, protecting water quality, and preparing water resource policies and plans. The ERA oversees regulation and licensing, and investigates matters referred to it by the Western Australian Government. No private sector providers exist in Western Australia. However, public private partnerships have been developed for a number of major infrastructure projects, such as the Perth Seawater Desalination Plant and the Woodman Point Wastewater Treatment Plant. The Water Corporation utilises the private sector via alliance contracts for operations and maintenance in Perth (Marsden Jacob Associates 1999, p. 85). Governance of urban water pricing National Water Commission 2009 stated that in Western Australia, water management responsibilities rest with various state and local organisations (National Water Commission 2009). 127

130 Figure 4.5: Management of water in Western Australia Local Regional State Water pricing and economic regulation Water planning and management Water markets Water supply and services Water supply and services Water quality management Private irrigation companies Ministers departments Urban water utilities Economic (National Water Commission 2009) Water availability Water supply In Perth, potable water is supplied from the Water Corporation s Integrated Water Supply Scheme, which also supplies water to goldfields and agricultural regions, including Kalgoorlie and Boulder to the east, and to many towns in the South West and Great Southern regions in the south (Marsden Jacob Associates 1999, p. 86). The Integrated Water Supply Scheme is a fully integrated water services system, regarded as one of the most complete water cycle management systems in Australia (Government of Western Australia 2007, p. 10). 128

131 Water within the Integrated Water Supply Scheme is supplied from a range of sources and at a variety of costs, as shown in Table 4.5 below (Marsden Jacob Associates 1999, p. 15). Table 4.5: Water Corporation s Integrated Water Supply Scheme supply sources Integrated Water Supply GL Operating costs ($/kl) Scheme supply sources Surface water Groundwater Desalination Water reclamation Total (weighed average of operating costs) (Marsden Jacob Associates 1999, p. 15) Perth relies on a greater degree of groundwater, that is around 60 per cent compared to any other Australian capital city. Water is drawn from a series of interconnected surface water sources, including Canning Dam, Mundaring Weir, Serpentine Dam, North and South Dandalup Dam, and Striling Dam. Around 60 per cent of the Integrated Water Supply Scheme water is drawn from groundwater sources, including the Gnangara and Jandakot mounds. Currently, both the Water Corporation and the Western Australia Government are examining the viability and sustainability of drawing water from the vast groundwater resources held in the South West Yarragadee Groundwater Aquifer (Marsden Jacob Associates 1999, p. 86). Supply demand balance As discussed, 95 per cent of the supply of water and wastewater in Western Australia is undertaken predominantly by the Water Corporation, which makes it a monopoly service provider (see Figure below) (ERA 2008, p. 14). 129

132 A report from Marsden Jacob Associates (1999, pp ) showed that Perth experiences long periods with little or no rainfall over the summer months. But yet water is typically used in gardens at a higher rate than in eastern Australian states. An estimated 50 per cent of total residential water use in Perth is for outside of the house. Since 2001, the Western Australian Government has imposed water restrictions on the metropolitan Perth area. However, the restrictions of two days per week have been relatively mild compared with the total sprinkler bans imposed by many other cities. In 2001, Perth residents used around 519 litres per person per day (around 30 per cent higher than the Australian average), of which 352 litres were used for residential purposes prior to the introduction of water restrictions. In , information from WSAA facts 2005 confirmed that the fourth year after the introduction of two days per week restrictions, residential water use per capita had fallen by 16 per cent to 294 litres per person per day. Other uses for water, including commercial, industrial, municipal and fire fighting, fell by 27 per cent per capita over the same period. In 2031, Perth s population is expected to grow from 1.8 million people to over 2 million. To be able to cope with this growth, the Water Corporation plans to develop a suite of sources over the next five years through the following: The establishment of a seawater desalination plant, known as Perth Seawater. The desalination plant (or Desalination No. 1) located at Kwinana, 40 kilometres south of Perth, which started supplying water to the Water Corporation s Integrated Water Supply Scheme in November It became the first plant in Australia to provide desalinated water for large-scale public consumption. It is also the Water Corporation s biggest single water source feeding into the Integrated Water Supply Scheme, providing some 17 per cent of Perth s water needs. On average, the plant produces up to 130 million litres of drinking water per day, or 45 GL per year (Water Corporation 2010). The Harvey Pipe Project, which is a three-year, $72 million project to pipe the Harvey irrigation district. The goal of this project is to pipe the balance of unpiped area in Harvey district by the end of 2009, which will result in the delivery of

133 GL of water savings that will be transferred to the Water Corporation on a permanent basis (Harvey Water 2010). The development of the South West Yarragadee Groundwater Aquifer is to provide 45 GL of water use in the Integrated Water Supply Scheme (Marsden Jacob Associates 1999, p. 88). Water and sewerage reform It is more important than ever in this uncertain Australian climate to ensure that the water business is structured in a way that is as innovative as possible. The effect of climate change is projected to be more pronounced in south west Western Australia than elsewhere in the country. The characteristics of the water and wastewater sectors are such that the structure of the water market will, at least in the short term, be different to other utility industries such as gas and electricity (ERA 2007, p. v). The key difference arises from uncertainty regarding water supplies; specifically the amount of inflows into dams and groundwater aquifers. Electricity and gas supplies can be forecast with relative certainty; however, there is great uncertainty over predictions of future water supplies. The current difficulty is difficult to establish how much climate change is affecting inflows, and whether a drought is compounding the problem. Any market price would therefore be likely to include a significant risk premium considering the investment needed in the face of uncertain future sales (Economic Regulation Authority 2007, p. v). One implication of uncertain future inflows in the water business is that storages have a value; that is, an opportunity cost of usage that can exceed the immediate cost of delivering water into the system. Opportunity cost is defined in standard economics textbooks as the amount lost by not using the resource (labour or capital) in its best alternative use (Begg, Fisher & Dornbusch 1987, p. 118). 131

134 A factor which can complicate the design of a bulk water market is when water in storage is used today and not replenished. The costs of meeting demand in the future may therefore be increased as additional and more expensive sources are required. A wellfunctioning competitive market may be able to effectively manage uncertainties by factoring in such opportunity costs. This type of market would take time to develop, and would require the introduction of an access regime and retail contestability (Economic Regulation Authority 2007, p. v). Western Australia water and sewerage reform A separate procurement entity An inquiry into the competition in the water and wastewater services sector in the Perth metropolitan region was reviewed by the ERA in The current arrangements for maintaining supply security have not convinced that the enhancements proposed by the Water Corporation will be effective. Some of the shortcomings include a lack of centralised coordination, without sufficient checks and balances, unclear delineation of roles and responsibilities, and a lack of opportunity and incentive for the private sector to develop alternative innovative supply and demand management options. The Independent Procurement Entity (IPE) would be established as a statutory authority with responsibility for ensuring least expected cost balancing of supply and demand within the Integrated Water Supply System, subject to the constraint of maintaining security of supply at a level set by the Western Australia Government (ERA 2008, pp ). The IPE would receive from the government a supply security requirement. The Water Corporation and various private sector proponents would then compete to provide the optimum supply demand balance which can be maintained at least possible cost. Subject to this security requirement, the IPE would identify future supply shortfalls, and seek ways to meet these shortfalls via supply augmentations and demand management options developed by the private sector and the Water Corporation. The water customers would fund the IPE through water tariffs. In return, the IPE would manage existing and newly acquired options to ensure security of supply was maintained at least possible cost (Economic Regulation Authority 2008, pp ). 132

135 4.7 Tasmania The industry Tasmania has only 1 per cent of the nation s land, yet it has around 14 per cent of Australia s water resources. This is a potentially significant comparative advantage for Tasmania. Urban water services are provided by 28 of Tasmania s 29 councils (excluding Tasman). The 29 local councils are Launceston, Break O'Day, Dorset, Flinders, George Town, Meander Valley, Northern Midlands, West Tamar, Burnie, Devonport, Central Coast, Circular Head, Kentish, King Island, Latrobe, Waratah-Wynyard, West Coast, Hobart, Clarence, Glenorchy, Brighton, Central Highlands, Glamorgan-Spring Bay, Huon Valley, Kingborough, Derwent Valley, Sorell, Southern Midlands, and Tasman (Department of Treasury and Finance 2007, pp. 3 4). There are three bulk water authorities in Tasmania: Hobart Regional Water Authority, which is the supplier of bulk water to councils in the southern region Cradle Coast Water Authority, which is the supplier of bulk water to councils in the north western region Esk Water Authority, which is the supplier of bulk water to councils in the northern region. These bulk water authorities are jointly owned by 18 of the councils. They supply bulk water to their owner councils and other councils, as well as other water users such as offpeak water for irrigation and to businesses directly. Sewerage services are provided by 27 of the 29 councils (excluding Flinders and Tasman). One of the three bulk water authorities supplies bulk water to 17 councils. These councils are generally responsible for collecting, treating and transferring bulk water. The remaining councils, with the exception of Tasman, are responsible for capture and treatment of their bulk water supplies. 133

136 Sewerage treatment services vary considerably in form and sophistication, as sewerage treatment infrastructure ranges from simple ponds or treatment tanks to complex arrays of tanks and mechanical equipment with electronic controls. In total, across Tasmania these providers service approximately water connections and sewerage connections. Governance of urban water pricing The National Water Commission (2009) maintained that in Tasmania, water management responsibilities rest with various states, regional and local organisations, as shown in Figure 4.8 below. Figure 4.8: Management of water in Tasmania Local Regional State Water pricing and economic regulation Water pricing and economic regulation Water planning and management Water markets Water markets Water supply and services Water quality management Rural water suppliers Regional water corporations 134 Ministers departments Economic regulator

137 (National Water Commission 2009) Water availability Water supply Marsden Jacob Associates (2006, p. 99) claimed that Hobart Water s water supply system comprises of water treatment, eight storage dams, pumping stations and pipelines, holding a capacity of 11 GL. The ratio of mountain to river sourced water is 40:60. In order to promote security to Hobart Water supply approximately 60 per cent of Tasmania s annual supply of water is sourced from Derwent River, 20 per cent from Mount Wellington catchment, and 20 per cent from Mount Field National Park. Table 4.3 shows sources of water supply for Hobart, in to (ML). Table 4.3: Sources of water supply for Hobart Derwent water supply Mount Wellington (Hobart) Mount Wellington (Glenorchy) Lake Fenton Southern regional supply Total (Hobart Water 2005 Annual Report , p. 8) The Water Development Plan for Tasmania (Department of Primary Industry, Water and Environment 2001; cited in Marsden Jacob Associates 2006, p. 99) stated that Hobart Water s total water allocation from all sources was 78 GL. Hobart Water does not have large storage reservoirs compared with the approach of most other Australian capital cities; its total storage capacity is less than one-third of its annual demand (Marsden Jacob Associates 2006, p. 99). 135

138 Supply demand balance Marsden Jacob Associates (2006, pp ) reported that Hobart primarily supplies bulk water to its owner councils. Hobart developed an off-peak market for irrigation and commercial users, and its off-peak users typically receive water during winter only. Hobart has not been subjected to severe water restrictions unlike Australia s mainland cities. Prior to 2003, Infrastructure and Resource Information Service noted that the regional water supplier had excess capacity but individual councils still imposed restrictions; these were not extended in later years. The only councils in Australia that charge residential water use on the basis of property value with an excess usage charge are the Hobart councils. There is no metering for water use, which means that many demand management options will be unavailable to Hobart councils, including signalling the cost of water usage through volumetric charges, or providing residents with information about their water use relative to other households. Water and sewerage reform As of 1 July 2009, new structural and regulatory arrangements commenced in the water and sewerage sector in Tasmania, wherein four new water corporations became the common service providers: Ben Lomond Water in the north, Cradle Mountain Water in the north west, Southern Water in the south, and Onstream. They replaced the three bulk water authorities and 29 local councils (Marchment Hill Consulting 2009, p. 3). The new structural arrangements were supported by enhanced regulatory oversight of the sector: The Water and Sewerage Corporations Act 2008 created powers to establish a new industry framework and new corporations. The Water and Sewerage Industry Act 2008 created the role of an independent economic regulator to oversight prices and service standards in the sector. It links the technical regulation of the sector with the economic regulatory 136

139 framework. This Act contains a series of pricing principles to which new corporations had to adhere from the commencement of the first regulatory period for the sector on 1 July By this date, the variable component of two-part water pricing was based, for each consumer on actual (metered) use. The Interim Price Order for the sector commenced on 1 July It provides for year-on-year price increases of a maximum of 10 per cent. 137

140 4.8 Summary After observing regulations across the states and territories, a number of broad similarities and differences can be detected. Australia s major cities are faced with serious long-term water challenges due to factors that include prolonged drought, water supply shortages as a consequence of prolonged drought, a drier climate, floods, wasteful water use and strong population growth. In response to these challenges, various measures have been put in place, such as alternative sources of water supply including the development of desalination plants, as well as pricing reforms and regulatory changes. In particular, the COAG water reform has resulted in separation of policy, and the regulatory and commercial function of most water utility businesses in major Australian cities. Water is managed on a state-by-state basis in Australia. There is a national approach to some issues; however, each state or territory retains ownership of its own water business. Up until recently, these water businesses underwent structural reforms as a result of the water reform process. Each state or territory has a government statutory that acts as the regulator of water businesses. This applies in all jurisdictions, regardless of whether the utilities are government or privately-owned (South Australia). The water utility provider is vertically integrated in all states and territories in Australia; an example of this is the combination of wholesale water capture and treatment, and final reticulation to the customer. In South Australia, SA Water undertakes bulk and distribution/retail functions to most parts of its respective state. However, it is difficult to achieve a one size fits all structure model for all of Australia s urban water businesses. Diversity is evident in water business structures throughout Australia s urban water industry. In terms of institutional arrangements, the water utility providers in South Australia and Western Australia have opted for state-wide water service providers. For instance, water utility businesses own and operate their assets in both of these states. Water service providers in South Australia own the assets, but maintenance of their infrastructure assets has been outsourced through a long-term contract to United Water, a consortium of private firms. 138

141 New South Wales, Victoria, Queensland and Tasmania have opted for local water service providers. In New South Wales, the state government owns the water service businesses for the cities of Sydney and Newcastle, while the local government is the owner of the water service businesses elsewhere. In Victoria, the water service provider for the city of Melbourne is disaggregated into a wholesaler; that is, Melbourne Water and the three retailers City West Water, South East Water and Yarra Valley Water. The nonmetropolitan regions of Victoria are served by a number of regional water service providers. All states have corporatised water entities at least in the major cities. The following chapter will provide a discussion of the current approach to urban water pricing and regulation in Australian jurisdictions. 139

142 Chapter Five: Urban Water Regulation and Pricing 5.1 Introduction Chapter Four provided an overview of the industry governance, structure and the broad area of ownership for urban water services in major Australian cities. The COAG water reform has resulted in separation of policy, regulatory and commercial function of most water utility businesses in major Australian cities. Similarities as well as significant differences between the organisation and the operation of the urban water and wastewater sectors in Australia s major cities were discussed. This chapter looks at the history of water pricing and institutional reform. After several reforms from the early 1990s, in 2004 the NWI became the blueprint of water reform in Australia, and most jurisdictions comply with the NWI s commitments. The key difference among the jurisdictions is in pricing functions among regulators, and reviewing bodies will also therefore be discussed in this chapter. This chapter then reviews the key differences in coverage of economic regulations between jurisdictions. The remainder of the chapter provides a background discussion of existing regulation and pricing structures in urban water and wastewater sectors in Australia s major state capital cities. Water businesses are subjected to licensing and other forms of regulations in all states and territories. An economic regulator is in place in every state or territory in Australia, which provides advice, arbitration and/or direction on water pricing and other financial issues in relation to water. Urban water businesses are either government- or state-owned corporations that operate under the corporation law. In most Australian cities, water businesses are owned by the state or territory government, except for Queensland, Tasmania and some regional centres in New South Wales. The local governments are owners of these water businesses. In Victoria, water businesses are owned by local governments, while there are some government-owned water businesses in regional urban centres around the state. The legal form of water businesses in Victoria is typically a commercialised division (arms of government departments) or the councils. Regardless of who owns the water businesses, there is generally little to no competition for customers. 140

143 5.2 Water pricing and institutional reform In 1994, water pricing and its institutional reform that began under the COAG s Strategic Water Reform Framework continued to evolve under the 2004 NWI best practice pricing and institutional arrangements. In 2004, the NWI became the blueprint for water reform through the agreement between the Commonwealth and state and territory jurisdictions at the COAG meeting. Recently, the 2010 NWI Pricing Principles were endorsed by the Natural Resource Management Ministerial Council. The COAG recommends the deprival value methodology for asset valuation for charging purposes. The 2010 NWI Pricing Principles are aimed at not only ensuring that pricing is primarily used to achieve economically efficient water use and service provision, but also to ensure financial viability of water service businesses. Three main agreed pricing reforms were implemented as follows: Full cost recovery to ensure that full efficient cost of providing water services to customers can be recoverable through prices charged. Structure of tariffs consumption-based component (variable) is to provide correct signal for efficient water usage. Fixed component reflects the fixed costs of service provision and is not based on property values. Efficient costs that are recovered through prices these costs must be sufficient to provide the levels of service that customers are willing to pay for, while the economic viability of water businesses is maintained in the long run. Independent regulators set water prices in major water businesses and bulk water utilities in the Australian Capital Territory and Victoria and for metropolitan water utilities in New South Wales. In contrast, prices are still controlled by state governments in other jurisdictions where independent bodies with limited pricing functions largely provide advice to these governments. Ultimately, water prices are either set or approved by governments, or reviewed by governments price-setting processes. 141

144 Another key difference addressed by the NWI (2011, p. 79) was the coverage of economic regulation between jurisdictions. In New South Wales, the IPART determines prices for metropolitan businesses, water planning and management charges. Bulk water services are provided by State Water, and the IPART does not determine water prices charged by local water utilities in regional areas. In Victoria, however, the ESC determines prices for all metropolitan, regional and rural water services. Regulators have limited coverage of water prices in some rural water services, such as in rural New South Wales, South Australia and Western Australia, where private irrigation providers determine infrastructure charges paid by customers. New transitional arrangements are in place so that prices of water in most jurisdictions can be set by the regulators. Progress has been made to strengthen economic regulations in the water sector in Tasmania, South Australia and Queensland jurisdictions. 5.3 New South Wales The IPART is the independent economic regulator for New South Wales, and it oversees regulation in not only the water but also the electricity, gas and transport industries. It undertakes other tasks referred to it by the New South Wales Government. In terms of the water industry, the IPART was established by the New South Wales Government in 1992 to regulate maximum prices charged for monopoly services by government water utility and its other monopoly businesses. Building block approach to determining revenue requirement For water utilities regulated by IPART, the revenue requirement must usually be sufficient to cover the efficiently incurred operating, maintenance and administration expenses of the utility, plus any return of and on the capital. This is represented in Figure 5.1 s formula, commonly defined as the building block approach: 142

145 Figure 5.1: The building block approach defined by the IPART R = O + M + A + C + D R = revenue requirement Non-capital costs O = operating expenses M = maintenance expenses A = administration expenses Capital costs C = return on capital D = return of capital (depreciation) As shown in Figure 5.1 above, the revenue requirement does not explicitly include capital expenditure, as it might be funded from return of capital, injections of equity or other borrowings (or other financing approaches) (Independent Pricing and Regulatory Tribunal 2009, p. 19). Return of capital Return of capital, commonly known as depreciation or maintenance of capital, recognises that through provision of services to customers, a utility s capital infrastructure will wear out and the cost of maintaining the capital base is therefore a legitimate business expense. It represents the opportunity cost of capital invested in a utility by its owner, and ensures that efficient investment in capital will continue for future maintenance and growth of the infrastructure system. A straight-line depreciation method is used to calculate return of capital for water businesses, which means that the total value of an asset is recovered evenly over its assumed life (Independent Pricing and Regulatory Tribunal 2009, p. 26). 143

146 Return on capital An allowance for return on capital is usually included in price-setting by the IPART, representing its assessment of opportunity cost of funds invested in these utilities. The IPART s approach to calculating return on capital is to use real pre-tax weighted average cost of capital (WACC) to determine an appropriate range for rate of return. It uses the Capital Asset Pricing Model (CAPM) to derive the cost of equity, and calculates the cost of debt as margin over the risk-free rate. Allowance for return on capital can be calculated by multiplying the utility s RAB by the WACC for each year of the determination period (Independent Pricing and Regulatory Tribunal 2009, p. 27). 5.4 Victoria Overview on ESC s approach to assessing water plans In Victoria, the ESC became the independent economic regulatory reviewer of the water business in The ESC determines water charges for all Victorian businesses, including electricity, gas, ports and rail freight industries. The ESC previously undertook a review of prices to be levied by 19 state-owned water businesses for a regulatory period of three years commencing 1 July As part of that process, the Water Industry Regulatory Order 2003 (WIRO) requires the ESC to ensure that the prices proposed by each of the water businesses allow them to recover return on assets in place as of 1 July The RAB is valued in a manner determined by, or an amount otherwise specified by, the Minister for Water at any time before 1 July 2004 (Essential Services Commission 2004, p. 4). Under the new economic regulatory framework established under WIRO, and as also noted in the ESC consultation papers, sewerage services and water prices will possess a formal relationship to cost and changes to cost. Prices will allow the water business to recover any costs incurred in operating and maintaining its assets, along with a commercial return on new capital expenditure, including return of funds invested over 144

147 time through a regulatory depreciation allowance (Essential Services Commission 2004, p. 7). In deciding whether to approve a business s proposed prices, firstly the ESC is required to assess the water plans against the regulatory principles as outlined in the WIRO. It must also be satisfied that they provide the water business with only enough revenue over the regulatory period to meet its obligations and deliver the level of service required by customers. The ESC must not allow monopoly profits, but instead ensure among other things that: revenue is sufficient to allow the business to recover operating and capital expenditure the water business receives a reasonable return on assets the expenditure forecasts reflect efficient delivery of the proposed outcomes outlined in the water plan, and take into account a long-term planning horizon the business has incentives to improve efficiency in delivering services to customers and to promote sustainable water use prices indicate towards the costs of use of water, and give customers various incentives towards sustainable water use customers interest is taken into account customers or potential customers are able to understand the prices charged including how they can be calculated. In assessing the proposed prices, the ESC s approach is often described as a building block approach, characterised by three steps (refer to Figure 5.2). The first step is to confirm the outputs or outcomes; for this, the ESC needs to identify the service standards, regulatory obligations (e.g. water quality, dam safety) and other outcomes that the business proposes to deliver over the regulatory period. All the standards and outcomes reflect obligations imposed by the Minister for Water through the Department of Human Services, the Department of Sustainability and Environment, and customer preferences for service improvements. It is crucial that customer service standards proposed by each business be clear, appropriate, and reflects the needs and interests of customers (Essential Services Commission 2009, p. 11). 145

148 Figure 5.2: Steps in assessing and approving prices Outputs/ outcomes - Service standards - Regulatory obligations (e.g. water quality, dam safety) - Demand and supply Step 1: Confirm outputs/outcomes Expenditure requirements - Service improvement - Compliance -Augmentation/ extension - Renewal Step 2: Determine revenue requirements - Cost of capital - Regulatory depreciation - Value of past investments Other financial inputs Prices - Structure of prices - Annual price control approvals Step 3: Translate into prices - Adjustments during period (Essential Services Commission 2009, p. 11) The second step is for the ESC to determine the revenue the business requires to meet its service obligations and expected outcomes identified in step one. Here, the ESC is required to assess whether the business s expenditure forecasts reflect efficient costs of supply, its capital works program is deliverable over the period, and its business strategy reflects a long-term planning horizon. It is the ESC s role to ensure that businesses receive return on their capital investments that reflect an efficient cost of capital. The ESC assumes efficient expenditure to assess whether prices will result in the business earning sufficient revenue to deliver services, but these assumed expenditure levels do not represent amounts that businesses are required to spend or direct to particular activities or projects. Businesses are free to determine their own expenditure priorities in light of changing circumstances, but customers have to be consulted prior to this. Businesses can also implement innovations and efficiencies that enable them to outperform the cost assumptions (Essential Services Commission 2009, p. 12). However, circumstances might change, which may result in a business not proceeding with a project or activity that it has proposed in its water plan and that was included in the ESC s calculation of assumed expenditure. This can occur when the business, in 146

149 consultation with its customers, identifies a higher priority project or activity that should instead be undertaken. However, costs may have increased by far more than forecasted at the time of the price review, leading to the business not being able to defer or cancel a lower priority project or activity. The projects and activities that are more highly valued by customers can still go ahead without causing revenue shortfall that has to be recovered from customers at a later date (Essential Services Commission 2009, p. 12). The third step in the process is to determine the prices that will apply during the regulatory period, and care must be taken by the ESC to ensure that for each business, prices generate its revenue requirement, taking into account forecasts of demand (which determine quantities expected to be used). In this final step, the ESC assesses whether the business s demand forecasts are reasonable and reflect the best information. Other considerations include whether prices and proposed tariff structures provide appropriate signals about the costs of providing services, provide incentives for sustainable water use, and take into account the interests of customers (Essential Services Commission 2009, pp ). Overview of revenue requirement Under the building block approach, prices set by the ESC reflect the revenue required to recover efficient cost of delivering services over a regulatory period, along with considering forecast levels of demand. The ESC has to be satisfied that the prices it approves will provide each business with sufficient revenue over the regulatory period to meet its obligations and deliver the level of service required by customers. It has to ensure that prices do not reflect monopoly rents or inefficient expenditure, and revenue required to deliver proposed service standards and outcomes must also be estimated. The revenue requirement reflects operating expenditure and a return on regulatory asset value, updated every year to reflect any additional capital expenditures, net of asset disposals and regulatory depreciation (Essential Services Commission 2009, p. 27). This building block methodology is used solely to assess whether prices will result in each business earning sufficient revenue to deliver services, and it does not represent the costs businesses are required to incur or direct to particular activities or projects. 147

150 Businesses are free to determine their own expenditure priorities after consultation with customers and taking into account the changing circumstances. It is their aim to pursue innovation and efficiencies that enable them to outperform the revenue benchmarks (Essential Services Commission 2009, p. 27). As part of the price review, the ESC has so far only assessed revenue requirements in relation to the metropolitan businesses water and sewerage services. Melbourne Water s revenue requirement for its drainage and waterways services is not subjected to the current price review, because the ESC approved prices for Melbourne Water s drainage and waterways services in the 2008 water price review final decision (Essential Services Commission 2009, p. 27). The ESC s assumptions Research by Marsden Jacob Associates (2004, p. 2) and clause 14(a) of the WIRO provision claims that assumptions made by the ESC are based almost entirely on use of a standard regulatory building block approach which takes account of: return on capital, through application of rate of return on the RAB return on capital, through depreciation allowance on the RAB operations, maintenance and administration expenses tax expenses adjustments for assets disposals, and possibly service standard incentives and/or efficiency incentives. These assumptions are closely linked to revenue estimations mechanisms outlined in the COAG Pricing Principle 4, which states: To avoid monopoly rents, a water business should not recover more than the operational, maintenance and administrative costs, externalities, taxes or TERs [tax equivalent regime], provision for the cost of asset consumption and cost of capital, the latter being calculated using a WACC [weighted average cost of capital]. 148

151 The ESC prefers this pricing principle as described in the regulatory building block approach. Experience demonstrates that this mechanism generally produces a revenue estimate that more than adequately ensures commercial viability. That is, there is less need to consider in detail the impact of cash outflows in the form of dividends to shareholders, actual debt costs or actual tax payments (Marsden Jacob Associates 2004, p. 3). The COAG Pricing Principle 5, however, provides a fundamentally different mechanism for estimating minimum or lower-bound commercial viability revenue. The mechanism associated with this principle does not require consideration of value of sunk assets or a rate of return. The COAG Pricing Principle 5 states: To be viable, a water business should recover, at least, the operational, maintenance and administrative costs, externalities, taxes or TERs (not including income tax), the interest cost on debt, dividends (if any) and make provision for future asset refurbishment/replacement (as noted in (3) above). Dividends should be set at a level that reflects commercial realities and stimulates a competitive market outcome. The COAG Pricing Principles use a number of terms that require further comment in the context of these guidelines, including the following terms used in Pricing Principle 5. The phrase not including income tax in Pricing Principle 5 only applies to those organisations that do not pay income tax: Externalities in Pricing Principles 5 and 7 mean environmental and natural resource management costs attributable to and incurred by the water business. That is, COAG Pricing Principle 5 requires explicit consideration of impact of cash outflows required for the ongoing, long-term maintenance of asset capability, actual cost of debt (if any), actual cost of tax equivalent payments and the possibility of dividend payments to shareholders. By comparison with the outcome associated with the COAG Pricing Principle 4 upperbound revenue estimate, particular care is generally required to test the adequacy of the 149

152 lower-bound revenue estimate (in much the same way that the ESC proposes) through comparison with financial ratios. This is because, by definition, the lower-bound revenue estimate only ensures commercial viability of the relevant entity. If cash outflows in the future require significant borrowings (which may occur from time to time during periods when the cost of capital asset maintenance exceeds the revenue allowance associated with future asset refurbishment/replacement), then it is essential to ensure that revenue is sufficient to assure bankability (Marsden Jacob Associates 2004, p. 5). Operating expenditure The businesses revenue requirements comprise of their forecast operating expenditure, a return on assets (existing and new assets) and regulatory depreciation (return of assets). The businesses set out assumptions underpinning their forecast levels of operating expenditure over the regulatory period in their water plans. The ESC identifies a reasonable trend in operating expenditure consistent with an efficient business in the draft decision. If it considers that the proposed operating expenditure does not represent a reasonable trend, adjustments are made to the operating expenditure benchmark (Essential Services Commission 2009, pp. 3 & 31). The operating benchmarks adopted by the ESC for each of the businesses represent assumptions about the overall level of expenditure to be recovered through prices that the ESC considers to be sufficient to operate the business and to maintain assets over the regulatory period. They do not represent amounts that the business must spend or allocate to particular operational, maintenance or administrative activities. It is important to note that if a business s actual operating expenditure during the regulatory period exceeds the benchmarks used to set prices because of inefficiency or additional expenditure on other activities, it is required to manage this rather than increase prices for customers. In contrast, if a business identifies additional ways to improve the efficiency of its operations during the regulatory period, which reduces its operating expenditure, it would allow the business scope to either improve services to its customers or to reduce the process below the maximum prices approved by the ESC. 150

153 The ESC will consider the businesses responses to the draft decision, and may adjust the relevant benchmarks for each business. Before the final decision, the ESC adjusts controllable operating expenditure benchmarks for all businesses. This final decision completes the ESC s review of metropolitan Melbourne water prices and service standards for the four-year regulatory period commencing on 1 July Melbourne Water reported that an operating expenditure benchmark over the regulatory period was increased by $10.1 million from the draft decision, compared with its proposal (draft) to increase it by $16.1 million (Essential Services Commission 2009, pp. III & 43). Capital expenditure Capital expenditure is a key component of revenue requirements under the ESC s building block approach, as The ESC is required to maintain the existing functions of water infrastructure. It is usually heavily benchmarked against past performance and/or other suppliers, to ensure that the proposal expenditures are efficient. Expenditures which are intended to improve levels of service, also termed as discretionary expenditures, need to be supported by evidence of willingness to pay on the part of customers. All the capital expenditures are subjected to scrutiny (often imposed by the ESC) regarding the efficiency of delivery and productivity savings (ICIL Tasman 2006, p. 5). Net capital expenditure is recovered by adding it to the RAB, and this is reflected in prices through a return on RAB; that is, the WACC multiplied by RAB and a return of RAB, through regulatory depreciation (Essential Services Commission 2009, p. 47). The WIRO stipulates that the ESC ensures that the prices levied by the businesses provide the business with a sustainable revenue stream that does not reflect monopoly profits or inefficient expenditure, and allows the business to recover expenditure on reviewing and rehabilitating existing assets. The businesses must also meet the ESC s requirements that the proposed expenditure forecasts are efficient and accounted for in a planning horizon that extends beyond the regulatory period of four years (Essential Services Commission 2009, p. 47). 151

154 The ESC will consider the capital expenditure benchmarks adopted in the final decision, which will allow each business to deliver its proposed services and meet known regulatory obligations. If proposed adjustments put forward by the businesses are not accepted, the ESC does not consider that it will restrict businesses abilities to recover sufficient revenue or meet their required levels of service delivery (Essential Services Commission 2009, p. 47). The ESC s final decision in its 2009 Water Price Review provided for a total capital expenditure of $4.1 billion over the regulatory period for the metropolitan water businesses. The total capital expenditure comprised of the following: $0.5 billion for City West Water a 15.6 per cent increase over the draft decision. $0.6 billion for South East Water a 12.1 per cent increase over the draft decision. $1.1 billion for Yarra Valley Water a 7.0 per cent increase over the draft decision. $1.9 billion for Melbourne Water an 8.3 per cent increase over the draft decision (Essential Services Commission 2009, p. 52). Financing capital investments The WIRO requires that prices allow each water business to recover its expenditure on renewing and rehabilitating existing assets. That is, a rate of return on assets on 1 July 2004 that are valued in a manner determined by, or at an amount otherwise specified by, the Minister for Water on any date before 1 July 2004, and a rate of return on investments made after 1 July 2004 to augment existing assets or construct new assets (Essential Services Commission 2009, p. 57). These WIRO principles allow each water business to recover the cost of capital investments that are initially funded by the water business over time, through regulatory depreciation and to recover financing costs through a return on assets. The next subchapter sets out the ESC s final decision based on the assumptions used by water businesses for financing capital investments; namely the initial regulatory asset values, 152

155 the rate of return on investments, and the techniques for calculating depreciation (Essential Services Commission 2009, p. 57). Regulatory asset base The RAB of each business represents the net value of its past investments for pricing purposes. The business recovers a return on assets calculated by multiplying the RAB by a regulatory rate of return. It is determined by the Minister for Water, and it reflects the initial regulatory asset value on 1 July 2004 and the net value of each of the new assets constructed by the businesses since then. It is adjusted each year to include new capital expenditure to deduct contributions, proceeds from asset disposals, and regulatory depreciation (Essential Services Commission 2009, p. 57). The ESC adopts a standard method for calculating an opening RAB for the regulatory period for each water business. The formula for calculating the opening RAB is: Opening RAB 2009 equals Opening regulatory asset value 2004 plus Gross capital expenditure less Contribution (by government and customers) less Proceeds from disposal of assets less Regulatory depreciation To update the RAB, the ESC adopted actual figures of capital expenditure, contributions and proceeds from disposals for the period 1 July 2004 to 30 June 2008, and forecasts for and the regulatory depreciation assumptions adopted for the regulatory period have also been updated. Once the opening RAB has been established, the same approach can be used to roll forward the RAB for each subsequent year of the regulatory period. Figures of capital expenditure, contributions, proceeds from asset disposals and regulatory depreciation are used for this calculation (Essential Services Commission 2009, p. 57). 153

156 Rate of return In order to estimate an efficient rate of return, the ESC uses a WACC, which reflects the cost of two alternatives sources of finance; that is, debt and equity. As the WACC is expressed in real post-tax items, benchmark assumptions about businesses tax liabilities will need to be incorporated with their revenue requirements. The return on assets component of a water business s revenue for any particular year is calculated as the product of average RAB for that year and the approved WACC (Essential Services Commission 2009, p. 59). In the draft decision, the ESC calculates a feasible range for WACC between 4.3 and 4.9 per cent. This range was calculated by accounting for probable ranges for a real risk-free rate and debt margin, the market-based WACC parameters, and point estimates for the non-market parameters. The ESC decision was to adopt a WACC towards the upper end of the feasible range based on a number of factors, and was mindful that in the months leading up to the draft decision, there had been significant cuts in the official target cash rate by the Reserve Bank of Australia that led to large decreases in the real risk-free rate (Essential Services Commission 2009, pp ). This was offset by severe tightening of credit markets, followed by increases in the cost of debt, and the final decision by the ESC was to adopt a real post-tax WACC of 5.1 per cent, which was towards the conservative (higher) end of the feasible range. It is considered that a rate of return towards the upper end of the feasible range is appropriate in recognition of volatility and the fact that it is difficult to forecast how financial conditions may change during the forthcoming regulatory period (Essential Services Commission 2009, pp ). The ESC also took into consideration the fact that the businesses often obtained credit at fixed rates and had to borrow at rates higher than the present levels. By adopting WACC towards the upper end of the feasible range, it was ensured that the businesses would be able to cover their actual costs of existing debt and the likely cost of future borrowings (Essential Services Commission 2009, p. 60). 154

157 Regulatory depreciation In the past, the ESC has approved straight-line depreciation profiles used by water businesses, and the reason for allowing a return of capital expenditure through regulatory depreciation when setting regulated charges is to return to investors the value of capital that has been invested over the life of the assets (Essential Services Commission 2009, p. 68). Final decision The ESC s final decision report completed its review of metropolitan Melbourne water prices and service standards for the four-year regulatory period that commenced on 1 July Its final decision resulted in a net $218 million reduction in revenue requirement proposed by the retail businesses. Price increases were significantly lower than initially proposed in the water plans, saving households up to $70 on their average annual water bills. Approved prices in the final decision were 2.7 to 3.8 per cent higher in , which was the final year of the regulatory period. It was higher than those proposed in the ESC s draft decision in April 2009 largely due to additional and revised capital and operating expenditures (Essential Services Commission 2009, p. III). The assumed financing costs, having risen from 4.8 to 5.1 per cent since April 2009, reflect recent market conditions and updated advice from the Treasury Corporation of Victoria on appropriate debt margins (Essential Services Commission 2009, p. III). 5.5 Queensland In Queensland, most water businesses set their own charges with the economic regulator, QCA, providing oversight only where matters are referred to it by the Queensland Government. 155

158 Pricing principles and methods The QCA objectives follow on from the requirements of the Queensland Competition Authority Act, which are firstly to guide the nature of the pricing principles, particularly in regard to protection of consumers from abuses of monopoly power, promotion of competition, efficient use of resources and other relevant public interest concerns (e.g. social and welfare, the impact on the environment). Secondly, third-party access seeks to promote greater utilisation of essential infrastructure facilities to increase competition in upstream or downstream markets, and to promote more efficient outcomes. Thirdly, competitive neutrality reforms seek to ensure that public sector businesses do not enjoy certain competitive advantages or disadvantages over actual or potential competitors. Certain requirements relevant to each element of monopoly prices oversight and thirdparty access (e.g. relevant to asset valuation) are generally consistent with requirements of competitive neutrality (Queensland Competition Authority 2000, p. 2). Methodology: maximum revenue requirement In approaching individual situations, the QCA sets a maximum revenue requirement that consists of the following three building blocks: An appropriate return on capital necessarily invested in the business. This requires determination of appropriate RAB and appropriate rate of return on that investment. Return of capital. The cost of operating a business in an efficient manner, including tax equivalents (where applicable) (Queensland Competition Authority 2000, p. 3). Regulatory asset base The value of the RAB needs to be established first, as it will provide an initial step in estimating building blocks underpinning maximum revenue requirements. The RAB is then applied to establish return on capital, and is determined by four components, including the following: 156

159 Estimate the deprival value of the relevant assets. In terms of monopoly prices oversight, it is likely in most cases to result in RAB being valued according to the DORC method. Optimisation of the asset network as part of the valuation process. At a minimum, entities should specifically account for unplanned excess capacity, to ensure that fully redundant assets are removed from the RAB. Adjust the RAB to account for reasonable capital expenditure, with such adjustments generally affected in the new period in which new investment is brought into use. Recognise capital contributions by including user funded or contributed assets in the RAB, and establish an offsetting arrangement with contributors or users. If there is no agreement, treatment of capital subsidies and grants from Queensland Government should be at the asset owner s discretion (Queensland Competition Authority 2000, p. 4). Return on capital After the RAB has been established, an appropriate return on capital needs to be estimated; one that should reflect the level of risk in relevant business activities. Rate of return is the return expected by investors in capital markets for investments of a given level of risk. It represents the opportunity cost to investors of expected returns on foregone investment opportunities; that is, the expected return from the next best alternative investment. The rate of return plays a central role in rewarding or compensating the asset owner for their past investment, and also in providing guidance as to the return on future investment in the network. For example, where rate of return is set above the business s actual cost of capital, there is an incentive for the regulated business to over-invest and to substitute capital for other factors of production (Queensland Competition Authority 2000, p. 41). 157

160 Weighted average cost of capital The WACC approach is generally considered the most appropriate method of estimating cost of capital for contemporary monopoly regulation. However, the QCA would need to establish a capital structure suitable to the individual characteristics of regulated business for the purposes of estimating the WACC (Queensland Competition Authority 2000, p. 42). Return of capital The QCA considers that the return of capital should be set to provide a cash flow sufficient to maintain the service potential of the relevant water asset/network. An asset consumption charge seeks to measure the decline in service potential from use of an asset. This charge is referred to as a depreciation charge or return of capital. Where demand warrants regular service provision, consumption charges should aim to provide cash flow sufficient to maintain the service potential of the relevant water asset/network (Queensland Competition Authority 2000, p. 43). For many water facilities, asset consumption and return on assets can represent up to per cent of the total economic cost of providing water services, suggesting that derivation of estimates for these cost components is a critical regulatory issue. A range of methods are used, including forms of cost-based depreciation or renewals annuity approaches, as long as it can be demonstrated that it meets the abovementioned objective. If renewals annuities are adopted, an asset management plan should be established by the relevant business activity to promote transparency, and the planning period adopted must be consistent with commercial principles, usually between 20 and 30 years (Queensland Competition Authority 2000, p. 43). Operating costs An appropriate estimate of operating costs of any regulated water business must represent efficient service delivery, based on the scale of operation and nature of activity being undertaken. It must be evaluated on an individual basis, and this usually includes 158

161 benchmarking against other relevant organisations (Queensland Competition Authority 2000, p. 46). Two-part tariffs Where prices need to be set, it should reflect long-run marginal costs. If such prices do not achieve revenue adequacy, two-part tariffs (fixed and variable charges) will best meet the objectives of efficient pricing, cost recovery and equity for most urban water businesses (Queensland Competition Authority 2000, p. 53). Pricing water In Queensland, delivery of water prices effectively represents (at least) two separate components: a price (cost) for infrastructure services associated with its treatment, transmission and distribution, and the price of water itself (Queensland Competition Authority 2000, p. 52). New developments The QCA ordered a third price review in 2010, which was conducted on the GAWB s pricing practices. The pricing model, although not publicly released, provided customers with indicative prices based on GAWB s proposed minor changes in the regulatory arrangements, consistent with the commercial framework (Queensland Competition Authority 2009, p. 3). Among other things, the most significant proposed changes to regulatory arrangements for five years of this regulatory control period ( ) has been changing the form of regulation from price-cap to revenue-cap. There is no change as to how the maximum revenue requirement is determined, and GAWB is not seeking to revalue assets, but is proposing a roll-forward of the 2005 DORC valuation. That is, the straight-line method of determining return of capital components of prices is to be retained. A review of WACC parameters was carried out partly due to the impact that the global financial crisis has had on the financial markets (Queensland Competition Authority 2009, p. 4). 159

162 Before the final decision is made, GAWB requested that the QCA makes recommendations as to whether it approves, rejects or requires alterations to the proposals contained in this submission (Queensland Competition Authority 2009, p. 4). 5.6 South Australia Overview As discussed in Chapter Four, South Australia has gone over and above plans for its current drought conditions to ensure water security in the state. Its most significant progress is the Adelaide Desalination Plant, which began catering to water needs in The ESC of South Australia (ESCOSA) is the state s economic regulator and reviews price-setting processes, underpinning water and wastewater pricing decisions made by the South Australian Government. The ESCOSA also considers whether the government's process for setting charges has adequately applied the COAG s principles. The South Australia Treasurer is responsible for budget deliberations and for monitoring SA Water s financial performance. It presents matters such as budget and relevant inter-governmental agreements to the Cabinet (South Australian Government 2009, p. 10). In June 2004, the South Australia Government signed the NWI, a 10-year reform agenda to improve the management of Australia s water resources. The NWI builds on the COAG Strategic Framework. The COAG s draft on national pricing principles, which built on 1994 s COAG Strategic Framework and the NWI, include the following: recovery of capital expenditure urban water tariffs recovering the costs of water planning and management activities recycled water and stormwater reuse. The ESCOSA, at the direction of the South Australia Treasurer and pursuant to part 7 of the Essential Services Commission Act, has undertaken inquiries since 2004 regarding 160

163 government processes for setting SA Water's water and wastewater (sewerage) charges. Its inquiries focused on application by the South Australia Government of certain pricing principles enunciated by the COAG in 1994, as well as the NWI in The underlying intent of these pricing principles is to improve the efficiency of provision and use of water services, for the benefit of the wider community. It can be concluded that the South Australia Government remains committed to COAG Pricing Principles and NWI s obligations (Essential Services Commission 2009, p. 1). Cost recovery of capital expenditure The South Australian Government (2009, p. 11) mentioned that charges for new assets, or those replaced after the legacy date of 1 July 2006, were set to achieve full cost recovery of capital expenditures through return of capital (depreciation) and return on capital calculated as the WACC on the depreciated RAB. New and replacement assets should initially be valued at efficient actual cost, and any assets existing as of 1 July 2006 (legacy assets) should be valued at DRC. The RAB, comprising of new and legacy assets, is rolled forward by adding prudent capital expenditure, and deducting depreciation and asset disposals. It is escalated at the expected inflation rate, consistent with WACC. Contributed assets should be excluded from the RAB. The upper revenue bound (URB) is the revenue that would result if all assets earned return on capital as per the WACC (South Australian Government, p. 11). Urban water tariffs The following approaches are used by the South Australian Government (2009, p. 12) for its urban water tariffs: Tariffs should be set to achieve forecast target revenue, which should move to URB. Two-part tariffs should be used, comprising of service availability charge and water usage charge. 161

164 Water usage charge(s) should be based on consideration of long-run marginal cost. Service availability charge for water should be based on the difference between target revenue and revenue recovered through water usage charges. The process of setting water and wastewater charges should be transparent and subject to public scrutiny. Ongoing business viability SA Water s financial viability is closely monitored by its management, the Board and the South Australia Government (as owner). Its key financial performance and viability indicators include areas like profitability and returns on investment; financial capacity to finance investment including new assets and replacement of existing assets; gearing; capacity to service and repay debt levels (interest cover); liquidity; and long-term cash flows (South Australian Government 2009, p. 11). Overview of revenue requirement SA Water s revenue should be high enough to ensure business viability, and it must be able to cover the full cost of service delivery and ensure that it does not earn monopoly rents (revenue is below the upper bound) (South Australian Government 2009, p. 15). In terms of efficiency, the COAG s Pricing Principles require that the URB includes efficient business costs (both operating and capital expenditure). This means that the outcomes that the South Australian Government seeks from SA Water should be delivered at lowest cost possible, taking into account the full range of costs such as externalities, equity and risk. In doing so, it requires that the combination of sources used to supply water to South Australia be in efficient balance with the available options. In other words, the capital expenditure on infrastructure is prudent (South Australian Government 2009, p. 15). The URB should also include new capital expenditure valued at an efficient actual cost. Efficiency, in a sense, should be delivered in a more technical way by taking into 162

165 consideration past capital decisions as given, and the organisation s existing operations should be conducted at lowest sustainable cost (South Australian Government 2009, p. 15). Regulatory asset base The NWI Commission s (NWIC) draft principles for recovering capital expenditure can be found in paragraph 22, which provides that the RAB should only reflect prudent capital expenditure: The RAB comprising prudent new investments and legacy investments should be rolled forward each year in accordance with the following formula that can be expressed in nominal or real terms: RABt = [RABt-1 + Prudent Capital Expendituret Depreciationt Disposalt (discarded assets)]. (Where t = the year under consideration). As in the above formula, SA Water s real RAB in any given year is its rolled-forward RAB from the previous year, plus capital expenditure less depreciation and disposal of assets. Assets that are contributed to SA Water, such as by grant of gift from a government or by customers, are excluded from the RAB where sufficient information is available to identify and value them (South Australian Government 2009, p. 15). Capital expenditure Capital expenditure was a significant factor in the and decisions, as substantial capital expenditure was planned by the South Australian Government to provide improved water security. The continuing drought has placed unprecedented pressure on South Australia s integral water supply, the Murray River, and in response the SA government has decided to take various steps to improve the state s future water security. Most notable is the decision to build a desalination plant at Port Stanvac. 163

166 When making its pricing decision, the government factored the cost of the desalination plant in, and it expected that water revenue be increased by a similar amount as the pricing decision (12.7 per cent (real) per annum) until , largely to meet the cost of these decisions (South Australian Government 2009, p. 15). Rolling forward asset values SA Water s RAB in respect of the decision was derived by the rolling forward of asset values as of 30 June The RAB is rolled forward in nominal terms including new capital expenditure and depreciation, and asset disposal is deducted. Existing asset values are escalated at 3.5 per cent per annum, consistent with the inflation forecast assumption in the real WACC calculation. It can be concluded that the South Australian Government s pricing decision is consistent with the COAG Pricing Principles, as SA Water s RAB has been rolled forward appropriately (South Australian Government 2009, p. 17). Return of assets depreciation In its pricing decision, the South Australian Government used the straight-line method over the estimated average useful lives of assets as the depreciation method. Further work has since been done to improve the estimate of useful lives of assets, and based on a preliminary analysis of SA Water s asset database as of 30 June 2006 and new assets commissioned in and , the regulatory depreciation is calculated using weighted average useful life. This is due to the different treatment of contributed assets and revaluation/escalation of assets (South Australian Government 2009, p. 17). The useful life estimates of assets adopted for the pricing decision are based on knowledge of performance of those assets, having regard to specific materials and operating conditions. Legacy assets, or those in existence as of 1 July 2006, are estimated to have an average useful life of 50 years. All other new or replacement assets have an estimated average useful life of 60 years. For new assets, this revised depreciation rate replaces the useful life assumed in the regulatory model, which was 100 years. The depreciation rate used for calculation of RAB was at 3.5 per cent per annum, and the 164

167 South Australia Government concluded that its pricing decision was consistent with the COAG Pricing Principles (South Australian Government 2009, p. 17). Operating, maintenance and administrative costs The main intention of the NWI is to ensure that water charges are efficient; the South Australian Government interprets South Australian obligations in this respect as ensuring that revenues, and therefore water charges, reflect reasonable forecasts of efficient operating, maintenance and administrative costs. There are two key factors in place to ensure that operating, maintenance and administrative costs are efficient: significant outsourcing and transparent public disclosure of costs and the basis for decisions, such as to build the desalination plant. Given these factors, the government considered SA Water s operating, maintenance and administrative costs to be reasonably efficient, and it acknowledges ESCOSA s comments in its final report that improvements could be made to increase SA Water s incentive to further improve efficiencies. While this is currently beyond the scope of this transparency statement, the government will continue to work with ESCOSA on this issue (South Australian Government 2009, p. 18). 5.7 Western Australia In Western Australia, the Water Corporation s revenue is set to recover total costs. It has been noted, however, that customer revenue from some of the Water Corporation s regional systems is less than what it would have received from application of lowerbound pricing. The West Australian Government practices a uniform pricing policy; that is, it charges the Water Corporation s customers the same amount for water, up to a certain level, wherever they live in the state. However, there is an economic principle that may be compromised by this policy the avoided cost pricing principle, which is consistent with the view that society is better off by providing services to only those customers who were willing to pay at least the costs that could be avoided if the service were no longer provided. The ERA is therefore 165

168 establishing whether alternative providers could provide the service more economically, such as an inquiry into the cost of supplying bulk potable water to Kalgoorlie. In the eastern states, the regional water system in Western Australia has been managed by one organisation. The Community Service Obligation policy is reflected in the difference between costs and revenues (Economic Regulation Authority 2006, p. 7). The ERA (2005, p. 54) assessed Western Australia Water Corporation s revenue requirements by using the building block approach to forecast the total revenue required for a predetermined period. The level of demand for services is assumed, and prices and tariff structures are then formulated to recover this revenue. The building block approach involved a bottom-up determination of total revenue from components, as shown in Figure 5.3. Figure 5.3: Western Australia s building block approach Assets Depreciation + Rate of return X Asset Value (RAB) + Forecast Operating & Maintenence Costs + = Total Revenue Identifying an appropriate level of revenue requires consideration of the level of return on assets, the allowance for depreciation that is necessary to reflect the ageing of assets, and the efficient level of operating and maintenance expenditure (OPEX). The asset value referred to in the formula above is often referred to as the RAB, and it is the value which has the most significant impact on average price for services. The RAB tends to 166

169 drive three-quarters of water businesses revenue requirements, and is increased each year by the net value of capital expenditure and reduced by depreciation. One way to determine an initial RAB is to consider the level of revenue that would be appropriate for the business, and then back-calculate the asset value given its forecasts of operating and maintenance costs, depreciation, and a rate of return on capital (Economic Regulation Authority 2005, p. 54). Key findings on Western Australia Water Corporation s revenue requirement operating expenditure The Water Corporation s operating costs per property are among the lowest of all water providers in Australia, but its staff levels are relatively high. Reference to the Water Corporation s operating expenditure is shown in Table 5.1 below, confirming that labour and hired/contracted services are the largest cost items other than depreciation. Even though the Water Corporation outsourced around half of its IT services and its technical engineering consultancy services, there may still be scope for up to 15 per cent reduction in total staff numbers, which would result in a saving of $20 million in operational costs in , increasing to $34 million in (Economic Regulation Authority 2005, p. 73). Table 5.1 Breakdown of Water Corporation operating expenditure, Item Value ($m) Share of total (%) Regulatory business Chemicals 13 2 Energy 35 6 Materials 15 2 Hired and contracted services IT and telecommunications

170 Item Value ($m) Share of total (%) Cost of assets retired 25 4 Costs of assets sold and disposed 7 7 Corporate charges 23 4 Plant and equipment 14 2 Other expenses 20 3 Depreciation Contestable business 12 2 Total (Economic Regulation Authority 2005, p. 57) Capital expenditure The Water Corporation s five-year capital investment program totals to $3 048 million, averaging to $610 million per year, and the projected level of capital expenditure from 2005 to 2009 was significantly higher than historical capital expenditure. This is mainly because of planned supply augmentation works and upgrades of the wastewater treatment system (Economic Regulation Authority 2005, p. 73). Depreciation The asset lives assumed by the Water Corporation are consistent with industry standards, although they appear to be at the lower end of the range identified. The Water Corporation has proposed use of a straight-line deprecation schedule based on the indexed regulatory asset value and standard asset lives. It has indicated that for future pricing inquiries, it will be worthwhile to consider renewals annuity methodology, as adopted in the United Kingdom. The Water Corporation is also proposing to write assets down, to reflect revenue forecasts for the next five years, as the choice of methodology will not affect the revenue level for this period. It is therefore proposed to continue with the current depreciation plus return on assets methodology (Economic Regulation Authority 2005, p. 65). 168

171 Rate of return An appropriate rate of return (cost of capital) for the Water Corporation was 6.5 per cent (pre-tax real). A key element of the required revenue for a regulated entity is the rate of return that investors, including both the providers of debt and equity, require in order to compensate for the non-diversifiable risks associated with the assets in which they invest. The ERA has used capital average cost of capital (CAPM) to estimate an appropriate WACC for the Water Corporation s regulatory assets. The WACC is the average cost of debt and equity capital, weighted by proportion of debt and equity to reflect the financing of the assets (Economic Regulation Authority 2005, p. 66). Initial RAB The RAB proposed by the Water Corporation of $9 100 million in was consistent with a value that preserves the revenue and average prices forecasted for the period to This method is consistent, in a general sense, with the line in the sand approach to asset valuation (Economic Regulation Authority 2005, p. 68). The line in sand approach recognises that past expenditures are sunk and are largely irrelevant for efficient decisions regarding usage and future investment. In essence, the value attributed to the existing business is a cost allocation process driven by questions of equity and acceptability to the stakeholders involved rather than efficiency per se. Value is measured in terms of income-generating ability; that is, customer benefit, being the sunk cost of the assets on which customers are not expected to provide a return (ACIL Tasman 2006, p. 4). In Western Australia, the initial RAB implemented in a framework of cost-based regulation of prices would return a set of regulated prices, and a value of expected revenue equal to current prices and expected revenue. The Water Corporation acknowledged that there is a degree of circularity in setting the initial regulatory asset value, and the value is based on expected revenue, while revenue for the determination period is based on the asset value (Economic Regulation Authority 2005, p. 68). 169

172 5.8 Tasmania In Tasmania, the Water and Sewerage Economic Regulator is responsible for implementing and administering the water and sewerage regulatory framework, in accordance with the Water and Sewerage Industry Act 2008 and its subordinate legislation (Government of Tasmania 2003, p. 3; Office of Tasmanian Economic Regulator 2008, p. 1). The Tasmanian Government is committed to implementing water business reforms as embodied within the Strategic Framework for Efficient and Sustainable Reform of the Australian Water Industry. This was part of the NCP agreements made at the February 1994 meeting of the COAG (Government of Tasmania 2003, p. 3). In relation to urban water pricing and within the Framework, councils are required to address reforms, particularly: implementation of two-part tariffs for water pricing, where it is cost-effective to do so adoption of water pricing regimes which achieve full-cost recovery, including requirement to meet long-term asset maintenance and renewal costs. The Urban Water and Wastewater Pricing Guidelines for the local governments, which are based on Agricultural and Resource Management Council of Australia and New Zealand (ARMCANZ) Full Cost Recovery Guidelines, have been prepared with the assistance of the Government Prices Oversight Commission (GPOC) to support councils in implementing the water reforms (Government of Tasmania 2003, p. 3). The ARMCANZ Guidelines for Water Pricing specifies that a likely future price regulation approach that embraces full cost recovery and use of building block approach to determine maximum revenue requirements (Office of the Tasmanian Economic Regulator 2008, p. 71). 170

173 The building block approach Using the building block approach, the Tasmanian regulator analyses each council s reported costs to supply, to ascertain an efficient cost to supply. The cost to supply must be ascertained to conclude the annual revenue requirement for each municipal area to meet operating and maintenance costs and depreciation (return of capital), and provide a commercial risk-adjusted return on its capital investment (return on capital) (Government Prices Oversight Commission 2007, pp ; Office of the Tasmanian Economic Regulator 2008, pp. 16 & 73 74). The building block approach discussed in the context of ARMCANZ Guidelines for Water Pricing was used to calculate the efficient cost of water and sewerage assets, as shown in Figure 5.3 below. Figure 5.3: The building block approach described by the ARMCANZ Guidelines for Water Pricing AARR = TC = AV*WAC C+D+OM Where: AARR = aggregate annual revenue requirement TC = total costs AV = asset value WACC = weighted average cost of capital D = depreciation OM = operating and maintenance expenditure 171

174 Operational, maintenance and administrative costs An allowance is made for efficient cost of operating and maintaining the systems, and administration costs under the building block approach. The revenue needs of each municipal area and each regional corporation have been established according to the upper limit of the ARMCANZ Guidelines (Government Prices Oversight Commission 2007, p. 14; Office of the Tasmanian Economic Regulator 2008, p. 74). The operational, maintenance and administrative costs are defined as follows: Operations operational costs are those costs incurred in operating the water system, including the cost of collecting, treating, testing and pumping the water, and will include royalties, chemicals, power and labour. Maintenance maintenance costs are the direct costs of maintaining the system, and include materials, internal labour costs and contractor costs. The total cost of maintenance will vary based on type, age and general condition of the assets. Administration administration costs include all overhead costs, salaried staff costs (including costs of planning and engineering staff) and other items such as Board costs, but exclude depreciation and interest costs (Government Prices Oversight Commission 2007, pp ; Office of the Tasmanian Economic Regulator 2008, p. 74). Asset consumption costs Depreciation is included in the building block approach to enable each of the providers to recoup the investment in water assets over the life of those assets, and to ensure future sustainability of the water business as it provides for return of capital. Depreciation on established assets is calculated on a straight-line basis by use of the regulator s estimate of average forecast economic lives of assets and the roll-forward asset values (Office of the Tasmanian Economic Regulator 2008, p. 78). 172

175 The methodology adopted to calculate depreciation is based on weighted average depreciation rate of all councils as the ratio of sum of total depreciation for and the sum of total asset values as of 1 July That is: Weighted average depreciation rate = Σ Depreciation (all councils) Σ Opening asset values (all councils) 1 July 2006 The weighted average depreciation rate for the water and sewerage sector was calculated at 3 per cent per annum. In relation to new assets, an average asset life of 70 years was assumed, which implied a depreciation rate for new assets of 1.3 per cent per annum (Office of the Tasmanian Economic Regulator 2008, p. 78). Highlighted reforms of Tasmania s water and sewerage sector Tasmania needs to have access to sustainable water and sewerage services to ensure that it is able to build sustainable communities and to maximise its economic opportunities. Water and sewerage in Tasmania is a very large business activity for its local governments. As shown in Table 5.2 below, the total value of the state combined water and wastewater infrastructure assets is approximately $1.7 billion (Government of Tasmania 2006, p. 6). Table 5.2: Asset values, Bulk supply Total assets ($ million) Hobart Regional Water Authority 189 Cradle Coast Water 70 Esk Water Authority 127 Council water assets 571 Council wastewater assets 725 Total $ million (Government of Tasmania 2006, p. 6) 173

176 There is growing evidence that Tasmania s water and sewerage infrastructure has not kept pace with the state s strong economic progress in more recent years. In 2005, Tasmania was ranked as having the worst water and wastewater infrastructure in Australia by Engineers Australia (Government of Tasmania 2006, p. 3). However, it has been noted that the cost of recovery benchmarks may not accurately reflect the true cost of maintaining the infrastructure on a sustainable basis, as it was noted by the GPOC that many of the councils have not undertaken comprehensive asset audits. Furthermore, during , 23 council water supply systems placed on permanent boiled water notices, some of which are key tourist towns in the state. It is obvious that in some council areas, sewerage and wastewater infrastructure is not delivering services at a level expected by residents (Government of Tasmania 2006, p. 9). This has directly affected Tasmanians and many other national and international tourists. Approximately 50 per cent of eighty-one plants in Tasmania are not compliant with their licence conditions. There was evidence of low levels of compliance with standards for Level 2 wastewater treatment plants (Department of Treasury and Finance 2007, p. 15). There is no consistency in the way water prices are determined by councils, as some have established charges based on how much water volume residents consume, while others charge for water based on alternatives methods, such as annually assessed value of the property. Tasmania s pricing methodology may not convey the true cost of providing the service. The lack of consistency and absence of proper pricing signals towards inequity across the state, and customers not being encouraged to use water wisely (Government of Tasmania 2006, p. 12). It was found in an analysis of the GPOC review of councils compliance with NCP Guidelines for urban water and wastewater pricing that the average returns in the sector were in the order of 2 3 per cent. This indicated that most of the councils were not generating a commercial rate of return from the infrastructure, which is incompatible with appropriate use of debt to fund investment. As indicated in Table 5.3 below, most of the councils produce a range of results for their returns, with the returns on wastewater greater than on water (Government of Tasmania 2006, pp ). 174

177 Table 5.3: Real rates of return Real rates of return Water Wastewater Negative 5 3 Less than 4 per cent per cent or more 8 11 (Government of Tasmania 2006, p. 16) 5.9 Summary of water pricing and economic regulation Table 5.4 below provides a summary of water pricing and economic regulations in Australian jurisdictions. Table 5.4: Water pricing and economic regulations in Australian jurisdictions Economic regulator New South Wales IPART Victoria ESC Key responsibilities Regulated services Who sets water prices? - Price determination - Metropolitan bulk IPART Metropolitan functions for the water, retail water, bulk and retail water, urban water industry wastewater, and rural bulk water - Recommends stormwater services water utilities, licensing guidelines and recycled water non-metropolitan retail to the Minister of - Rural bulk water - 5 private irrigation Water companies, rural retail - Price determination - Urban bulk water - ESC and service and retail water, standards monitoring sewerage services, metropolitan drainage services, recycled water services - Rural bulk water, 175

178 Economic regulator Queensland QCA South Australia ESCOSA Western Australia ERA Tasmania Economic Regulator of Water and Sewerage (Commissioner Price Oversight Key responsibilities Regulated services Who sets water prices? retail water and irrigation drainage services - Price local government recommendation, councils, urban bulk review of pricing and retail policies, third-party - SunWater, rural bulk access and price and retail for SunWater monitoring water supply schemes - SEQ water, rural bulk and retail for SEQ Water Supply Schemes - 12 water boards, rural retail - Review - - South Australia government pricesetting Cabinet, urban retail - 27 private irrigations, rural retail - Price - - Western Australian recommendation Cabinet, urban bulk and - Oversight for urban retail and rural water - 3 cooperative pricing practices irrigations, rural retail - Regulate water and - Urban bulk water - 3 urban retail water sewerage prices and retail water, corporations - Monitor annual sewerage services - 5 rural retail irrigation performance entities 176

179 Economic regulator Commission) Australian Capital Territory ICRC Key responsibilities Regulated services Who sets water prices? - Price - Urban retail water, - ICRC determination and sewerage, waste licensing water and bulk water, trade waste and water reuse (National Water Commission, 2011) 177

180 5.10 Summary Water regulators use the building block approach, where periodic price reviews are conducted. The building block approach adopted by Australian water regulators is a similar terminology, although differences are substantial in the approaches adopted by other utilities such as airports, electricity, gas and telecommunications. Annual operational expenditure and a rate of return on and of a RAB are used to determine a revenue requirement to be recovered from customers. The upper-bound pricing described by the COAG Pricing Principles, as well as principle 4 of the National Competition Council (NCC) 1998 (pp ), is that efficient cost is achieved as the aggregate of return on and of capital, the efficient capital base plus operating expenses. Regulated monopoly utilities services such as water have applied this efficient cost principle to set the maximum price. Efficient tariff structures are required for efficient water pricing. Water businesses in Australia and elsewhere in the world have therefore adopted two-part tariffs, where the variable volumetric charges reflect the long-run marginal cost of water supply. When the marginal cost of supply is equal to the price, it is then that economic efficiency is achieved. The long-run marginal cost of providing new water sources is reflected in the variable volumetric charge, known as inclining block tariffs, which can comprise of one or more blocks or tiers (up to 11). For example, a one block tariff is used by Sydney Water, while an 11 blocks tariff is practised by Albany and Kalgoorie-Boulder Water Corporation in Western Australia. A fixed service charge allows water businesses to recover all remaining administrative and other asset costs. Water prices should reflect the marginal cost; that is, the full cost to society from providing a good or service, including any externalities such as environmental impacts. To date, externalities are not reflected in water delivery prices. Water pricing and its institutional reform began in 1994 when the COAG set up its Strategic Water Reform Framework. This was followed by the 2004 NWI best practice pricing and institutional arrangements which became the blueprint for water reforms. Most recently the 2010 NWI Pricing Principles were endorsed by the Natural Resource Management Ministerial Council. These pricing principles are aimed at ensuring that 178

181 water pricing is used predominantly to achieve economically efficient water use and water service provision, and that water businesses are financially viable. Most Australian jurisdictions comply with these NWI commitments. In general, the current approach to urban water pricing varies across Australian jurisdictions, with the key difference being pricing functions among regulators and reviewing bodies. The independent regulators set water prices for major water businesses and bulk water utilities in the Australian Capital Territory and Victoria, and for metropolitan water utilities in New South Wales, whereas in other jurisdictions prices are still controlled by state or territory governments. The other significant difference is coverage of economic regulation between jurisdictions. For instance, prices for metropolitan businesses and water planning and management charges is determined by the IPART in New South Wales, but the IPART does not determine water prices charged by local utilities in regional areas. In contrast, water prices for all metropolitan, regional and rural water services is determined by the ESC in Victoria, while private irrigation providers determine infrastructure charges paid by customers in rural New South Wales, South Australia and Western Australia. The next chapter will focus on asset valuation techniques used in water businesses. 179

182 Chapter Six: Asset Valuation Techniques Used in Water Utility Businesses 6.1 Introduction This chapter focuses on a range of issues associated with the valuation of water utility assets. It begins by discussing some general issues related to the definition and recognition of an asset. The asset recognition criteria are conventional. Firstly, an asset is expected to provide future economic benefits; and secondly, an asset must be controlled by the entity. Thirdly, the basis for measurement of the value of an asset is its cost, and it must be able to be measured reliably in monetary value. Accurate asset valuation is important, because the rate base used in the calculation of MAR for the pricing of water is a key determinant of a water business s performance. That is, the asset base which drives revenue requirements, price and asset valuation has major consequences for defining total costs of providing the relevant service and pricing decisions passed on to water customers. In earlier chapters, we discussed the methodology used to regulate urban water prices, which is the building block approach a standard approach also used to regulate other utility sectors (e.g. airports, electricity and gas, and telecommunication) in network infrastructure. The building block approach consists of three building blocks: return on capital, return of capital, and appropriate estimate of efficient operating costs. It is used to determine the amount of revenue in which the water business can efficiently operate to remain commercially viable. The key ingredient of the building block approach is RAB, which comprises of physical assets. On the other hand, capital costs comprise of return on capital (allowed rate of return) and return of capital (depreciation). Based on the MAR equation, the RAB (asset value) is a significant determinant of the asset base. As the asset value (RAB) and the WACC dominate the revenue calculation over other terms, at least in the asset s early life, valuation of asset base is of fundamental importance for this component of cost. One expert claimed that asset valuation determines 80 per cent of the MAR when applied. 180

183 Accurate asset valuation and capital cost allowances are important for generating appropriate prices. The higher the asset valuation, the higher the revenue needed to generate the required return on assets, and hence the higher the prices charged to consumers and vice versa. Accurate asset valuation will encourage efficient network usage and efficient investment in the medium and long term. Along with the issue of price regulation, the problem of circularity also arises in a natural monopoly, as its assets are considered specialised with no alternative use. The regulator s original intention is for the RAB to be used to determine asset value, which depends on revenue expectation; however, it cannot at the same time be the basis for setting revenue. This chapter provides a brief comparison between various asset valuation approaches for water utility businesses, followed by an overview of the deprival value. There are two main techniques used in asset valuation: value- or market-based, and costbased. Valuation of an asset is determined largely from its cash-generating capacity under the value- or market-based approaches; while cost-based approaches either relate the value of an asset to the cost of purchasing the asset, or are dependent on the service potential embodied in the asset at the original cost or the original cost adjusted to reflect its current cost. The costs would include any cost incurred in set-up or acquisition of the asset, along with any associated financing costs. The third approach, deprival value, is a hybrid approach that considers both value-based and cost-based approaches to arrive at an asset value. If the entity was deprived of an asset, deprival value is the value of future economic benefits that would be foregone. That is, if the asset is lost or replaced, it can be valued at its market price, replacement cost or reproduction cost, depending on the circumstances. 6.2 Recognition and measurement of assets Asset values are used in the determination of MAR required by water regulators, and hence they act as an important basis for determining both appropriate return of capital (depreciation charge) and return on capital. When cost of capital is applied to the asset 181

184 value, it determines the amount of revenue required to earn an appropriate return on capital. Water businesses capital costs generally consist of both the return on and of capital, both of which represent the amount with which the business can recover, along with its operating costs, through its charges. However, it is important that the assets are valued appropriately. When the business s revenue exceeds its capital and operating costs, it will earn a return in excess of its cost of capital. In such instances, it would be exploiting a position of market power. In accounting, for a transaction or event to be recognised as an asset, it must meet three fundamental definitions of an asset, and then satisfy the recognition criteria. Finally, it must have a cost or other value that can be measured reliably. Asset recognition criteria are mostly conventional. Specifically, it must be probable ; that is, more likely rather than less likely that service potential or future economic benefits presented by the asset will in some sense be realised. The asset must have a cost or other value that can be measured reliably, as per the SAC 3, Qualitative Characteristics of Financial Information (Steering Committee on National Performance Monitoring 1994, p. 23; the Institute of Charted Accountants in Australia 2010, p. 36). Asset valuation information should also satisfy the other concepts sets out in SAC 3: reliability, comparability (Chapter 3: Qualitative Characteristics of Useful Financial Information, QC20 QC25) and understandably comparability (Chapter 3: Qualitative Characteristics of Useful Financial Information, QC30 QC32). SAC 3 was withdrawn and superseded by Chapter 3 Qualitative characteristics of useful financial information of the AASB CF Amendments to the Australian Conceptual Framework (December 2013). In 1990, the COAG set up the SCNPM of Government Trading Enterprises with the purpose of monitoring the performance of Australia s major government trading enterprises in the electricity, gas, transportation, communications and water industries. The SCNPM of Government Trading Enterprises guidelines (1994, pp. 2 6 & 23 30) defined and measured an asset the same way as the Statement of Accounting Concept 4 (SAC 4), Definition and Recognition of Financial Statements, paragraph 14 (SAC 4), which has been replaced and is now known as the AASB Framework for the Preparation and Presentation of Financial Statements. 182

185 Australian accounting standards provide guidance in relation to recognition and reporting of assets. In particular, relevant definitions and commentary on assets are specified in the Framework for the Preparation and Presentation of Financial Statements, published by the AASB in This framework superseded Statements of Accounting Concepts 3 (SAC 3) and Statements of Accounting Concepts (SAC 4) on 1 January Definition of an asset can be found in paragraph 49(a) of AASB Framework for the Preparation and Presentation of Financial Statements (December 2009) and SCNPM of Government Trading Enterprises (1994, p. 23). The main points are: future economic benefit control past transaction. Paragraph 89 of AASB Framework for the Preparation and Presentation of Financial Statements (December 2009) states: An asset is recognised in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. The two essential components of recognition are: Firstly, it must have probable future economic benefits probable means that it is more than less likely that the benefits will be realised. Secondly, it must be able to be reliably measured; it should have reliability, which means faithful representation of underlying transactions or events, without any bias or error. Essentially, a third party would come to a similar value if presented with information relating to transactions or events. Next, the basis for measurement of value of an asset is its cost. Paragraph 15 of the IAS 16/ AASB 116 Property, Plant and Equipment (June 2009) outlined this in: 183

186 For an item of property, plant and equipment to qualify for recognition as an asset, it shall be measured at its cost. With reference to not-for-profit entities such as water utility businesses, if an asset is acquired at no cost, or for a nominal cost, the cost of this asset is its fair or market value as at the date of acquisition. Assets are defined as resources controlled by an entity, and they must be a result of past events from which future economic benefits are expected to flow to the entity. Once a transaction or event fulfills these three fundamental characteristics, recognition criteria are necessary. The AASB Framework states that for an asset to be recognised, future economic benefits must be probable and capable of reliable measurement. An asset also requires a cost or other value which can be measured reliably. The IASB is presently reviewing the Conceptual Framework for Financial Reporting, and issued an Invitation to Comment (ITC 29) in July 2013 as a proposed way forward. The IASB proposes the new definition of an asset in paragraphs of ITC 29: that proposed definition of an asset is a present economic resource controlled by an entity as a result of past events. Arguably, the proposed new definition of an asset is more relevant than the existing one to the public sector, such as the water industry, because it makes no mention of future economic benefits flowing to the entity. In the case of the public sector, future economic benefits of the asset do not flow to the government as owner, but to the public who use the asset (goods or service). In the public and government sectors, the right to dispose of the asset is very restricted, especially within the present regulatory environment. 6.3 Asset valuation Following the discussion of recognition and measurements of assets, the issue of physical asset valuation for water businesses is of critical importance. Both the COAG and the NWI Pricing Principles (2010, pp. 4 & 6) state that a water business is regarded as part of a capital-intensive industry with minimum decline in book value. The business uses a large portion of capital to buy expensive assets (i.e. pipelines, pumping stations and storage tanks) and for replacement of its existing assets, to expand the stock of assets so 184

187 as to meet increases in demand, and to meet standards and any increases in regulatory obligations. However, with these additional expenses there is greater financial risk. Asset valuation has major consequences for defining total costs of providing the relevant service and pricing decisions passed on to water customers. The IPART (1996, p. 42) claimed that over $90 billion is invested in assets in replacement cost terms, which makes water businesses one of Australia s largest and most capital-intensive industries. The National Productivity Report (NWI 2011, p. 16) claimed that in , capital and operating expenditure by urban water utilities from providing water and wastewater was more than $13 billion, of which $7.7 billion was for capital expenditure. This included capital expenditure on new works, renewals or replacements, and water recycling assets. In relation to asset valuation, a key ingredient of the building block approach is the RAB, comprising of physical assets. It represents the value of investment upon which the owners earn a return, and the return over the economic life of the assets (regulatory depreciation). The IPART reported in its 2004 Electricity Price Determination that capital-related costs represent a significant component; in fact, up to 70 per cent of the total cost of providing regulated distribution services is capital (Country energy 2003, p. 1). In line with this, Davies and Zauner (cited in Johnstone 2003, p. 3) maintained that when assessed on a replacement cost basis, capital costs are typically per cent of total costs. Johnstone (2003, p. 2) noted that the building block model can be categorised as period costs of owning (financing) and operating the necessary transmission infrastructure assets and totals these to give a maximum or upper limit (a price cap) on allowable period of tariff revenue. Expressed as a formula, the MAR in period t is: Operating expense + depreciation + opportunity cost. Return on capital is the opportunity cost; that is, the dollar return on capital that could have been earned had a cash amount equal to the period of opening asset value that was 185

188 invested elsewhere for that period. Capital costs comprise of return on capital (allowed rate of return) and return of capital (depreciation). From the above equations, RAB (i.e. the asset value) is a significant determinant of asset base. The RAB is multiplied by the WACC to determine the return on capital. WACC is the return on capital employed, and includes appropriate risk allowances and profit. Zauner (2000, p. 1) pointed out that asset lives are often long, such as 50 years, and depreciation per annum is 2 per cent, and the WACC is in the order of 7.5 per cent. Therefore, the asset value (RAB) and the WACC dominate the revenue calculation over the other terms, at least early on in the asset s life. Valuation of asset base is of fundamental importance for this component of costs. In fact, Zauner claimed that asset valuation determines 80 per cent of the MAR when applied. Operations and maintenance costs, tax and adjustment for new capital expenditure (capex) are generally small relative to the first two terms (operations and maintenance costs and tax and adjustment), and are not further considered in this thesis. Return of capital (depreciation) measures decline in service potential to ensure that it is matched against revenue earned by the asset, so as to give a fair estimate of the asset owner s return on investment. Depreciation is of significant importance, as it is a part of the assessment process of asset valuation. The AASB 116/ IAS 116, Property Plant and Equipment (June 2009) definition of depreciation is as follows: Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value. Depreciation provides two key information sets for public sector entities, such as those of water businesses. Based on the building block formula, depreciation is the rate at which the entity s asset base is used up, and it is the information crucial for pricing of services. In the context of asset capitalisation, depreciation is an important determinant of current fair value of an asset. Paragraphs of the IAS 16/ AASB 116, Property Plant and Equipment (June 2009) provide guidance to applying the concept of depreciation to parts of assets. 186

189 Figure 6.1: Recognition of an asset (Australian Infrastructure Financial Management Guidelines 2006, p. 2) Figure 6.1 above illustrates how an asset is recognised at its cost of acquisition, with an estimated residual value and an estimated useful life. The asset is depreciated over its useful life down to its residual value at the time when it is planned to be replaced or disposed of, in case the service provided by the asset is not required. Inappropriate calculation depreciation of a water asset utility will produce inappropriate asset valuations; likewise, inappropriate depreciation methods may distort decisions related to maintenance and replacement of water assets infrastructure (Queensland Competition Authority 1999, p. 2). Indeed, both the return on and of (depreciation) capital depend on the RAB, and for the purpose of this thesis, depreciation is the dependent variable. The building block formula illustrates that the RAB affects the calculation of MAR. Asset valuation is a key determinant of water businesses performances which drives revenue requirements and prices. Accurate asset valuation and capital cost allowances are important in order to generate appropriate prices. If the return on capital (asset valuation) is set too high, the water business would be encouraged to invest in network to an excessive extent. Customers 187

190 would be required to pay too much for using the network, and hence it would result in monopoly rents being extracted from customers (Queensland Competition Authority 2001, p. 10). Similarly, if return on capital is set too low, the water business would not be compensated adequately for its investment. Consumers would pay a lower price for their water usage in the short term; however, it would then be unlikely to undertake further investment in the network, which would potentially lead to inefficient allocation of resources across the economy (Queensland Competition Authority 2001, p. 10). Asset valuation by government trading enterprises such as those of water businesses has important implications for financial reporting and performance, and significant direct and flow-on effects on pricing of goods and services provided by government trading enterprises. Government trading enterprises have to price their goods and services in order to achieve a target rate of return on their investments and assets. The issue of application of an appropriate assets base to be used is crucial for price-setting purposes (Independent Pricing and Regulatory Tribunal 1996, p. 1). Accurate asset valuation will encourage efficient network usage and efficient investment in the medium and long term. However, it may not be desirable for water utility businesses to delay investment until demand exceeds capacity. Any new investment should be based on reasonably anticipated future demands, as excess capacity may be dynamically and allocatively inefficient (Queensland Competition Authority 1999, p. 1; 2001, p. 9; Ministry of Economic Development 2002, p. 21). Equally important, it is undesirable from an efficiency perspective for the business to over-invest in facilities. Investment planning should therefore aim at ensuring that there is an appropriate level of investment to support production, with no excess, or under, capacity. Inaccurate asset valuations tend to distort prices of water to end users of this commodity delivered via the network. That is, if the price of water is set too high, it will undermine the competitiveness of water businesses in both domestic and international markets (Temple-Heald 1991, p. 1; Queensland Competition Authority 1999, p. 1; Ministry of Economic Development 2002, p. 21). 188

191 6.4 Role of asset valuation and regulatory control issues Deloitte Energy & Resources (2010, p. 2) mentioned that water utility assets are valued for the purpose of asset replacement and management programs, transfer of assets from one water business to another, impairment testing, and determination of the assets carrying values for annual financial reporting. The IPART (2000, p. 79) acknowledged that valuation of assets and accounting for major infrastructure projects (e.g. water utility) is one of the most difficult and challenging tasks. The valuation of assets is important in the determination of revenue (i.e. the regulated water prices) by the regulated water utility business for two main reasons. Firstly, asset valuation is the basis for the determination of appropriate return of capital, the depreciation charge. Secondly, cost of capital is applied to the asset value to determine the amount of revenue required to earn an appropriate return on capital. Both return of and on capital form the business s capital costs that would be recouped, along with its OPEX through its charges. When the business s revenues exceed its capital and operating costs, it will earn a return in excess of its cost of capital, although a business that persistently earns excess returns is likely to be doing so by exploiting a position of market power. Prices are set independently of asset values in competitive markets. In theory, in any market the EV of an asset is ultimately determined by the NPV of the cash flows it can generate. That is, the value of the business s assets is determined by its revenue, prices and volumes. In a competitive market, market forces determine prices, and prices in turn determine the asset value. This assists in providing an equitable basis on which to charge prices. The efficient price outcome would provide appropriate opportunity cost signals, irrespective of whether investments should be undertaken and maintained. On the contrary, in a natural monopoly market, such as those of water businesses and where assets are specialised, a circularity problem arises as shown in Figure 6.2 below. 189

192 Figure 6.2: Circularity of prices, revenue and asset value Price of water Maximum allowable revenue (MAR) Regulatory asset base (RAB) (Independent Pricing and Regulatory Tribunal 1996, p. 12; Queensland Competition Authority 1999, pp. 2 3) Figure 6.2 above illustrates the circularity problem associated with the methodology used to value sunk assets. The government sets the revenue through price regulation, taking a fair rate of return into consideration, and the revenue earned by the government trading enterprises depends on the RAB. That is, as water prices increase, the asset value will increase and vice versa. It highlights the interdependency between product (water) price, asset value and revenue (Independent Pricing and Regulatory Tribunal 1996, p. 12; Queensland Competition Authority 1999, p. 2). Such issues of circularity have received heavy criticism from academics and lawyers such as Bauer (1924, pp ), Bonbright (1926, pp ) and Southworth (1922, pp ), and via a series of sessions in the papers and proceedings of the American Economic Review in 1924, 1927 and By 1928 the debate was at its height. Kahn in his classical text on regulation (1988, cited in Grout & Zalewska 2001, p. 4) asserted that inability to value assets in the face of circularity had become an industry standard. This was evidenced by Bauer in 1918, when he noted that the circle of value and rates has been pointed out perhaps a thousand times (Bauer 1918, pp ; Grout & Zalewska 2001, p. 4). 190

193 In the absence of a competitive environment where market forces will determine demand, prices and hence asset values, the provision of services by the business, in a regulated environment, is often not contestable. It is therefore necessary for the regulator to play a role in the valuation of assets. That is, the higher the prices charged by a natural monopoly, the greater the discounted cash flows received by the business, and as a result the higher the value of the business s assets. A natural monopoly might be able to charge almost any level of prices as being no more than a normal or competitive rate of return on the assets committed to the business. It is important that assets are valued appropriately, as only when assets are valued independent of prices, can efficiency of the business s pricing and returns on the value of its assets be adequately assessed. The main concern with regard to asset valuation in a business operating in a market where competition is limited (i.e. natural monopoly) is that it may operate less efficiently. This could potentially be due to the use of a greater amount of assets or assets of a higher quality than required or necessary, or that it would employ if it were to operate in a competitive market. The regulator must therefore ensure above normal returns on capital are not permitted (Ministry of Economic Development 2002, p. 105). Another issue is that only those assets that are currently used and useful would be included in the asset base on which a rate of return is calculated. Optimisation is a cost analysis approach used in asset valuation; it is a condition in which efficient pricing can be achieved. The business rebuilds its existing system using modern techniques, technology (where technology had changed) and assets for replacement of the system. Costs that should be recovered through pricing are those that reflect the least cost of production. However, when combined with minimised operating costs, optimisation will result in the optimal (minimum) cost of providing services. The optimised system will represent least cost, modern equivalent replacement assets that would provide service the potential of existing assets (Queensland Competition Authority 1999, p. 9; PricewaterhouseCoopers 1999, p. 3; Ministry of Economic Development 2002, p. 105). All other assets should be optimised out, so that the business is only permitted to earn a return of and on only at an efficient level of assets, as well as to ensure that current and 191

194 future customers are not asked to cover the cost of this investment through access prices. The QCA (1999, p. 7) specified that the optimisation process should provide for elimination of redundant assets and excess capacity. Excess capacity is the difference between actual and theoretical/engineering capacity; the excess capital assets should be optimised out of the business s asset base. Investment in water infrastructure is by its nature lumpy, and there is likely to be a degree of excess capacity that needs to be taken into account in the asset base. The excess capacity should therefore be incorporated in the asset valuation to determine the purpose of setting a ceiling price. Unless an allowance is made for this characteristic of water infrastructure, there will be an adverse impact on the infrastructure owner s incentive to invest. More importantly, use of optimisation should be beneficial in providing incentives for the business to ensure that it invests in appropriate technology, prevents gold-plating of its assets (i.e. goods or services supplied of a higher quality than what would be demanded by consumers, such as through over-designing of the assets), assets being constructed inefficiently (i.e. doubling up), and reducing the risk of inefficient bypass of the existing assets, if there is any. Due to a lack of alternatives, consumers are forced to pay higher than efficient prices. Bypass occurs when it is cheaper for current purchasers of network services to construct and operate an alternative service themselves rather than use the existing network. Consumers should not have to pay for all these (over-investment, goldplating and any inefficient past investment). Optimisation for valuation purpose is not concerned with improving the system from its current state. In fact, the system should never be valued as better than it is, regardless of terms of capacity or other standards. Optimisation leads only to reductions in replacement costs of network system assets (Australian Rail Track Corporation Ltd 2001, p. 30). It should instead assist in providing an equitable basis on which to charge prices, and hence it is important that efficient pricing signals the economic cost of the consumption of services (Queensland Competition Authority 1999, pp. 3 4; Ministry of Economic Development 2002, p. 90). An investigation by PricewaterhouseCoopers (1999, pp. 3 4) found that an important concept associated with asset valuation is based on replacement cost subject to optimisation. Optimisation of assets recognises that system assets will 192

195 practically never be rebuilt in exactly the same configuration, over the same location, using exactly the same materials as originally utilised; thus making its system assets theoretically more efficient. However, inclusion of optimisation in the asset valuation process often involves a social cost the trade-off of the creation of investment risk. There is therefore the need to compensate investors for such risk against reduction in investor moral hazard a situation refers to a person s weakened incentives to act prudently when they do not bear all the costs of their actions and/or inefficient bypass (Ministry of Economic Development 2002, p. 111; Commerce Commission 2002, pp. 5-6). 6.5 What is deprival value? Originally, the deprival value was a concept used in insurance. It referred to whether the owner was deprived of an asset; that is, the asset was lost. The replacement cost meant the amount of compensation that the owner would have to receive to leave them indifferent to the loss of the asset. The replacement cost, as its name suggests, is the cost of replacing an asset with another asset on a new-for-old basis. The replacement asset does not necessarily have to be the same asset, but will provide the same services and capacity as the existing one. Asset valuation are carried out based upon how much it would cost to replace the asset today. For the water business, if it is deprived of the value of the asset, under the replacement cost rules this should leave it indifferent, with an assurance that it can continue to provide the existing market with an equivalent flow of services. The settlement amount, if the water utility business is deprived of its assets, is an exit value notion. That is, there is an incentive for efficient investment decisions, as assets are valued in current prices. The concept of the deprival value originates from Bonbright, a scholar and Professor Emeritus of Finance at Columbia University in Bonbright s views on deprival value were set out in two of his books, The Valuation of Property (1937) and Principles of Public Utility Rates (1961). 193

196 The deprival value, as on page 72 of the book, is: When I say, My house is worth $10,000 to me, I mean (if I am precise in my use of language) that retention of the house is worth to me as much as the acquisition of $10,000 in cash would be worth to me. However, this is the same thing as saying that the anticipated loss of my ownership interest in the house has an adverse value to me of $10,000. Such negative terms including anticipated loss, damage, and injury are simply the converse of such positive words as value, worth and importance. It can be said that an asset s value to the owner is the loss they would suffer if deprived of the asset. The deprival value is the amount of money that would make up the loss and would make them whole. In other words, deprival value looks at liability following the loss of an existing asset. It also attempts to answer all the important questions, such as what difference would it make if the owner is deprived of the asset? If x is the unit of asset, deprival value, as a set of valuation rules, looks at exactly how much an owner would be worse off with (x-1) asset units. Various working definitions of the deprival value can be found, such as the working definition adopted by the SCNPM (1994, pp ): in most cases [deprival value] will be measured by the replacement cost of the services or benefits currently embodied in the assets. The replacement cost is the cost which is the cheapest and the most efficient way, using a MEA. It is based on the technology of the day and current market values (Commerce Commission 2002, p. 7; Utilities Commission 2005, p. 12). The SCNPM (1994, pp ) added an extra element to the determination of deprival values, which is the consideration of whether or not the assets would be replaced if they were no longer available. Under these guidelines, where an asset would be replaced, the deprival value is taken to be the current replacement cost of the asset or of an alternative asset with the same service potential. Such a definition is consistent with the deprival value of assets being the lesser of the NPV of the income able to be generated by the asset and the DRC of the asset, or the DORC value of the asset. 194

197 Depreciation of a replacement value reflects the age of the existing asset and is not explicitly contemplated. That is, an accountant may interpret the terms similar asset and the same service potential as taking into account the age of the existing asset and hence valuation at DRC or DORC. The most important issue with interpretation in reference to the deprival value is to understand the circumstances under which the asset owner would be deemed to replace an asset if the business was deprived of that asset (and hence the circumstances when the deprival value methodology would result in an asset being valued at the DORC value). Under the guidelines developed by the SCNPM, there is an expectation that a business generally would replace assets that were being used, regardless of whether the replacement of the asset would be economic; that is, the provision of the service generates a return at least equal to the cost of capital. In New Zealand, assets are only valued at replacement cost if NPV of revenues from the asset exceed the cost of the asset. Assets are only deemed notionally to be replaced when the utility would be under implicit or explicit service obligations to continue to provide the service (ACCC 1999, pp ). A regulator can reduce the value of assets when it is aware that a more efficient lowercost alternative asset is available. The replacement cost, if it can in fact be replaced, is its value in exchange in the market where the business can purchase the asset. The replacement cost seeks out to answer the question: What will it cost the business to get rid of (replace) a present-day asset with an MEA that could provide a similar level of service to the asset in question? In the case of a water utility business, in order to replace assets, it would use the most economically efficient technology and a corresponding inventory of capital assets with the same remaining life as the actual assets. Deprival value answers the question: What would it cost today to provide an asset to deliver the same service potential as the asset being value? (Bertram 2000, p. 3) A rationale for this valuation rule is that the business would acquire the asset because the return it will secure on its investment would exceed its cost. When deprived of the assets, the business would not lose those returns, but would replace the assets of equivalent 195

198 value. The extent to which the business is better off as a result of its ownership of the assets is represented by the replacement cost. 6.6 Background information of the ODV The ODV is a variant of deprival value, and it relies on the deprival concept. The opportunity cost, amount lost by not using the resources, such as labour or capital in its best alternative uses, of infrastructure asset is low, and the outlay from investment in these assets cannot be recouped by reselling the assets for some other use. In many cases these assets will never be replaced. Existing water pipelines may be renewed or upgraded, but it is unlikely that they will ever be scrapped and rebuilt (Independent Pricing and Regulatory Tribunal 1996, p. 85; Ministry of Economic Development 2002, p. 108; Deloitte Energy & Resources 2010, p. 2). The portion of the asset s value that cannot be recouped is called sunk cost. For such sunk assets, replacement cost cannot be a measure of opportunity cost, as opportunity cost in relation to alternative uses of such assets is very low or even zero. The owner forgoes very little in its present use, as their assets are being used optimally, and there is no alternative use once built. An oft-quoted saying in economics is that bygones are forever bygones (Jevons 1888, p. 164; Peart 1996, p. 105; Bond & Sakornvanasak 1996, p. 40; New Zealand Institute of Economic Research 2000, p. 5). Given the large, sunk, long-life investments associated with water businesses activities, and the fact that such assets invested are used optimally, their investment behaviour is of critical importance. Over- or under-investment will have direct implications on prices charged to consumers (Ministry of Economic Development 2002, pp ). 6.7 Overview of asset valuation techniques In order to understand the concept of ODV methodology, the concept of the deprival value needs reviewing. The deprival value is the amount of loss to a business if it were obliged to forfeit the asset in question. 196

199 Assets are valued at an amount that represents the loss of service potential flowing from the asset. Asset valuations are one of the most difficult, controversial and challenging issues associated with determining the revenue requirement of a service provider. The main reason is that because valuation of water utility assets is not related to a competitive market, there is no specific procedure for asset valuation which is necessarily correct or suits all accounting, performance monitoring and price regulation. The IASB/ FASB has previously discussed the measurement objective, but this concept has remained rather confusing and controversial. This is because issues related to measurement (valuation) cannot be considered independently from the context of some underlying objective for financial accounting and reporting. The FASB/ IASB is currently grappling, as part of its conceptual framework revision and major concerns include whether there is any likelihood of international agreement on a single measurement objective, given that there is a lack of homogenous users and uses (SCNPM 1994, pp. 31 & 34; Solomon 1995, pp ; Johnstone & Gaffikin 1996, p. 53; National Asset Management Steering Group 2001, p. 1.2; Walker & Jones 2003, pp ; Cooper 2007, pp ; & Macve 2010, p. 111). There is little consensus on a measurement approach, although the issue of measurement in financial reporting has been widely discussed by both professional and academic accounting forums for decades. The AARF (1994, p. 13) suggested that measurement is one of the most significant contemporary issues in financial reporting. This is reflected in the Australian accounting standards Framework for the Preparation and Presentation of Financial Statements, paragraph 100, where a variety of measurement techniques and guidelines for measurement bases are employed to different degrees and in varying combinations in financial statements. This thesis discussed earlier that one of the most important aspects of determining the RAB is the choice of asset valuation methodology. That is, the asset valuation methodology used could have significant consequences for the RAB, the MAR and consequences, and the prices charged to consumers. If the price of water is under-priced, it will erode the capital base and the capacity of the water utility business to remain 197

200 financially viable. Similarly, over-pricing will result in consumers being extracted of monopoly rents. Ideally, the choice of asset valuation methodology should be established in a regulatory framework. However, in practice, the asset valuation methodology is not defined in the regulatory framework. There are a variety of techniques of asset valuation available, depending on the choices of valuation available to entities. There are two main techniques used in asset valuation: value- or market-based, and cost-based. Figure 6.3 depicts each approach and the various accompanying asset valuation techniques. Figure 6.3: Overview of valuation techniques Net present value (NPV) Valuebased Costbased Historical cost (HC) Hybrid Deprival value (DV) Net realisable value (NRV) Replacement cost (RC) Optimised deprival value (ODV) Fair (market) value Depreciated optimised replacement cost (DORC) Line in the sand (Queensland Competition Authority 1999, p. 5; PricewaterhouseCoopers 1999, p. 2) With the former value- or market-based approaches, valuation of asset is determined largely from its cash-generating capacity. This can be measured either by the NPV of future cash flows (i.e. the value to the user of the asset), or the NRV, which is the cash generated by selling the asset. In general, value-based approaches require significant amounts of information and assumption. It is therefore potentially affected by the problem of circularity, where the asset value is determined by (regulated) prices and 198

201 revenues which, in turn, are based on the asset value (Queensland Competition Authority 2000, p. 32; KPMG 2005, pp. 4 8). The latter cost-based approaches relate to the value of an asset to the cost of purchasing the asset. It also depends on the service potential embodied in the asset, either at the original cost or the original cost adjusted to reflect its current cost. Cost-based approaches, such as historical costs, are more easily established. This includes any cost incurred in the set-up or acquisition of the asset, along with any associated financing costs. As the original purchase price of the assets is supported by documented evidence, such as receipts or invoices, it is not only less costly to establish, but also administratively efficient. All data required is available from the financial statements. Also the business invests in capital; any cost savings will subsequently be passed on to consumers in the form of lower prices. These cost-based approaches do not require experts to determine cost, as they rely on actual data rather than professional judgements. They also reduces the risk to asset owners of the impact of technological change. However, cost-based approaches are less relevant to current and future economic decision-making, particularly for long-life assets during persistent periods of inflation. That is, the asset prices will be understated in times of high inflation, while during times of technological change the asset prices will be overstated. For water businesses, it is difficult to determine accurately the lives of some water assets, as it may well be more than 100 years. This may lead to unstable prices, which may rise when the asset is new, and drop when more expensive assets are used to replace existing assets. Arguably there are limited incentives for the business to increase its capacity or make services available to more users, because it does not get compensated for doing so. Other cost-based approaches include replacement cost and DORC (Queensland Competition Authority 2000, p. 32; Australian Competition and Consumer Commission 2009, p. 97). 199

202 There is a clear and constant asset valuation allowance until the expiration of the assets. For these reasons, the depreciated actual cost (DAC) is widely accepted as the basis for recording asset values by the commercial sector and for financial accounting purposes. Figure 6.4: DAC valuation method - Asset disposals or retirements = Ending asset balance + Prudent capital expenditures - Regulatory accumulated depreciation = Opening values Depreciated actual cost (DAC) = Net asset balance The existing assets may become obsolete due to technological change. The DAC would overstate efficiently incurred cost, causing productive inefficiency and distorting consumption decisions, causing allocative inefficiency. For this reason, the DAC does not take into consideration the impact of inflation and technological changes. The main disadvantage with this method in the valuation of water businesses assets is the problem associated with the long-life assets and lumpy (sunk) investments. As such, the DAC may not accurately reflect the adequate rate of returns to owners that is required to maintain the financial and operating capability of the water business. The owners may therefore not be able to fully fund new investments. It has little resemblance to the EV of the assets, and has no direct relationship with future cash flows generated by an asset in its normal use. The DAC method takes into account depreciation, but it does not consider periodic inflation. The depreciated inflation historical cost (DIHC) is a variant of historical cost. In 200

203 Figure 6.5, the asset historical value is adjusted for inflation by applying either inflation or appropriate indices to the actual capital costs. The asset value under the DIHC is consistent with a regulatory regime, as it allows a real rate of return after inflation is adjusted on the calculated RAB. Thus, the DIHC is a form of CCA. Figure 6.5: DIHC valuation method - Asset disposals or retirements + Index allowance = Ending asset balance + Prudent capital expenditures - Regulatory accumulated depreciation = Opening values Depreciated inflation historical cost (DIHC) = Net asset balance The decisions incorporated into the DAC and DIHC techniques are all appropriate for taxation and accounting purposes. That is, customers pay for the actual network provided and not the market value of the network assets or technology changes that occurred, since the assets were constructed because of changes in asset designs or regulators decisions. As in Figure 6.3, the third approach, the deprival value, is a hybrid approach that considers both value- and cost-based approaches to arrive at an asset valuation. The NWI 2010 (p. 7) stated that the deprival value is the value of future economic benefits that would be foregone if the entity was deprived of an asset. If the asset to be lost was to be replaced, it can be valued at its market value, replacement cost or reproduction cost, depending on the circumstances. Otherwise, the asset should be valued at its EV, which is 201

204 the greater of either the NPV of the income expected to be earned from the asset, or the fair market value if it is not to be replaced (National Water Initiative 2010, p. 7). Deprival value has been endorsed by the COAG as the preferred approach to valuing network assets for public reporting processes (performing monitoring) and the ARMCANZ (Australian and New Zealand Environment and Conservation Council, and Agriculture and Resource Management Council of Australia and New Zealand) as a basis for water pricing. It is considered to be the best estimate of what a private sector provider would pay for a similar asset, provided that the expected market and other conditions prevailed (Queensland Competition Authority 2000, pp ). When the businesses are deprived of the asset and the recoverable amount exceeds the replacement cost, then the businesses would probably go and buy another asset as a replacement. It is therefore logical for a business to follow the deprival value when it makes a rational value-maximising decision. The replacement cost will set a maximum amount on the loss that the business can suffer through deprival. However, if the economic benefit that arises from the ownership of the asset (i.e. the recoverable value) is less than the cost of replacing it, then the business would logically choose to keep the asset rather than replace it. The recoverable value will depend on what the business is planning to do with the asset, whether it considers making the most money or derives other benefits from it. There are two basic choices: either to sell it (value in exchange), or to use it within the business (value in use). It is logical for a business to choose whichever offers the highest return. The NPV of the future cash flows described previously is the value in use and the present value of future cash flows obtainable as a result of the continued use of an asset, including those resulting from the asset final disposal. It involves use of techniques like the discounting future cash flows. An example in which value in use or NPV of future cash flows is an appropriate determinant of its value to the business is where an old specialised machine which would not be replaced as it is still producing cash flows with a NPV exceeds the asset s net realisable value. Under these circumstances, the business will retain and use the asset rather than sell it. On the other hand, the asset s NRV is the value in exchange of a sale, or in other words the sale proceeds less the future costs of sale. 202

205 The New Zealand Institute of Economic Research (2000, p. 8) maintained that the historical costs approach was rejected on the basis that the prices it gave rise to were unsustainable. When new assets were added, a shock in the price occurs. Historical costs valuation was therefore considered inequitable over time, as the service did not change with the price change. Therefore, even though historical cost is considered potentially the most objective and lowest cost method, records are somewhat inconsistent. Government trading enterprises (i.e. government authorities which provide goods and services directly to the community and are responsible for the provision of electricity, gas, telecommunications, rail transport services and water) have a high proportion of long-life assets ( years) which have been purchased and invested at various points of time. In Victoria, the ESC reported that some of its large infrastructure projects are recovered over years, while its other expenditures may have a shorter depreciation life. These assets are therefore subjected to different price levels. Historical cost figures may have limited application under these conditions, and may fail to provide a meaningful base for performance measurement. Other limitations of HCA include overstatement of profit unless there is no inflation, as well as leaving a business unable to replace its assets (Independent Pricing and Regulatory Tribunal 1996, pp. 15 & 84; Lee & Fisher 2004, p. 351). As an example, research by Logan City Council in Queensland identified one of its reinforced concrete pipes as having a useful life for 100 years; however, in reality it could last for more than 200 years (Kennedy 2006, pp. 1 12). An extreme example of water assets that are long-term and capital-intensive assets with low rates of technological obsolescence (i.e. subject to optimisation of excess capacity) can be witnessed in Rome and Italy. In these countries, the modern sewerage system still uses some assets installed by the ancient Roman Empire, dating back to 600 BC about years ago (Hopkins 2007, pp. 1 15; Deloitte Energy & Resources 2010, p. 7)! The deprival value is classified in the third hybrid approach as shown in Figure 6.3. It considers both value- and cost-based approaches to arrive at an asset value (Queensland Competition Authority 2005, p. 5; Australian Government 2010, p. 15). In theory, the deprival value is drawn on principles set by Bonbright in 1937, which is conceded, in 203

206 particular, by Solomons (1960, pp ; 1995, pp ) and Baxter (2003, pp. 1 23). As discussed, specialised assets are those that are employed in non-contestable or monopoly markets. In particular, water utilities are specifically recognised as natural monopolies, where they are characterised as being the largest supplier that has an overwhelming cost advantage over actual and potential competitors. Therefore, it is not possible for competitors (suppliers) to enter the existing market. In addition, water pipelines are very expensive to build and have no alternative use. Facts from Australian Water Association (2007, p. 47) have specified that water is too heavy to be transported. That is, 1 KL (1 000 litres) of water weighs approximately one tonne. Additional energy is therefore required to move water, to overcome frictional resistance. It takes pump power to drive the water through, and extra pump energy is required to lift the water if the pipelines have to climb up a mountain range. Thus competition in the water business is impossible. Other characteristics of water business are such that there are large sunk investments, a large share of fixed costs, and economies of scale and scope. It is therefore unlikely that a potential competitor would be willing to make the capital investment needed to enter the natural monopolist s market. The fair (market) value accounting is most commonly used by investors in commercial entities. It is known to be an appropriate concept to capture business risk, capital structure and economic valuation based on expected future stream of income. However, the assets of government trading enterprises, such as those of water utilities businesses, have no market values, and in the absence of a competitive market, the deprival value approach is considered an appropriate starting point from the regulatory perspective. The line in the sand valuation is an asset valuation technique presently not discussed in any published academic journals. NERA Economic Consulting and PricewaterhouseCoopers (2009, p. 16) noted that the line in the sand valuation has been proposed by utilities asset owners and accepted by regulators in Australia. It can be expressed as the EV limb of the deprival value technique. The line in the sand valuation is adopted by Australian regulators to establish the initial RAB for the purpose of 204

207 determining the price of utilities, including water. Future capital expenditure undertaken after the initial line in the sand valuation is rolled into the RAB at cost. In adopting this technique, regulators consider a wide range of factors to ensure that the initial RAB is locked in and set to deliver a specified outcome such as a targeted level of price for customers, a targeted level of revenue or a targeted level of profitability for the business. NERA Economic Consulting and PricewaterhouseCoopers (2009, p. 2) emphasised that this technique requires a choice on the exact measure of current outcomes, whether it involves setting the initial RAB consistently with maintaining prevailing prices, revenues or profit into the future. When the initial RAB is locked in and set, the valuation had no particular regard or relation to asset valuation undertaken for financial reporting purposes. Using this asset valuation technique may result in inefficient prices being set from the initial RAB. Existing or current prices may have locked in inappropriate asset valuation which includes some form of monopoly profit and is carried forward into future prices. Similarly, if low current prices are locked in with low level of capital investment, an asset valuation based on current prices will result in losses carried forward into the future. For example, the ESC in Victoria first approved the price of water (and the provision of sewerage services) that each water entity may charge its customers from 1 July 2005 for regional urban businesses and from 1 July 2006 for rural businesses. The RAB is used for the purpose of determining the price of water under the regulatory regime. The initial RABs of the metropolitan water businesses were set higher than their financial reporting asset values. On the other hand, the initial RABs of the regional and rural entities were set lower than their financial reporting asset values and carried into the future. The initial RABs of the rural water businesses were set to zero. This resulted in a large depreciation expense not recovered through the price water charged to customers by the regional and rural water businesses. Over a period of time, the difference between the RABs and financial reporting asset values grew, magnifying the shortfall between the prices of water charged to customers and the revenue required to recover efficient operating costs. The Victorian Auditor General pointed out that this is the key factor contributing to the operating losses in a number of regional urban and rural water businesses in Victoria (Auditor-General 2013, pp ). 205

208 6.8 Summary An item or event should meet three fundamental characteristics to qualify as an asset of an entity. The asset is expected to provide future economic benefits and it must be controlled by the entity, and occurrence of transaction or event must be of the past. The asset must satisfy the recognition criteria. That is, the asset must have a cost or other value that can be measured reliably. Physical asset valuation is important for water businesses. In 1996 it was reported that over $90 billion was invested in assets in replacement cost terms. The National Productivity Report claimed that capital expenditure for all urban water utilities in Australia for was estimated at $7.7 billion. Water businesses use a large portion of capital, to buy expensive assets such as pipelines, pumping stations and storage tanks. It is also expensive to replace the existing assets, to expand the stock of assets to meet increases in demand, and to meet standards or any increases in regulatory obligations. Water businesses spend a substantial amount of expenditure on investment, as well as maintenance of assets to supply, treat and deliver water, and then collect, treat and dispose of wastewater. A high proportion of long-life assets, from years, are owned by water businesses, and these assets were purchased and invested in at various points of time. For example, the ESC in Victoria reported that some of its large infrastructure projects are recovered over years, but its expenditure may have a shorter depreciation life. Logan City Council in Queensland identified that one of its reinforced concrete pipes had a useful life of 100 years, but in reality these concrete pipes can last for more than 200 years. In Rome, Italy, the modern sewerage system still uses some assets installed by the ancient Roman Empire, dating back to 600 BC. These are all examples of water assets being long-term, capital-intensive assets with low rates of technological obsolescence subjected to optimisation of excess capacity. Water businesses assets do not have alternative uses and they are effectively considered sunk. No accounting or economic theory therefore provides determination of an initial RAB value for the assets of an established water business. Economic theory, however, 206

209 has suggested that the setting of a regulatory value for monopoly network assets at a particular time is typically interpreted as within a feasible range; that is, at the upper bound or lower bound. When the RAB on which price of water is based is equal to longrun marginal costs, the price of water will also equal this. Paragraphs 4 and 5 of the COAG provide a description of upper bound and lower bound. That is, economic efficiency criteria is satisfied when the assets are valued between lower bound and upper bound of costs incurred by an efficient new entrant (bypass cost). The upper bound is the estimate of the DORC, while the lower bound is the value that assets would have in their next best use. Upper bound is the value in which the asset should be scrapped and a new asset installed. It would be better off for consumers at any price above the upper bound to have a new entrant to enter the market in competition with the existing network. In contrast, at any price below the lower bound, the water business would not be able to cover its cost and it would suffer financially if it kept on serving its consumers. Once investment in water assets has been made, its outlay is considered sunk. This outlay cannot be recouped by re-selling the assets for some other use. This is because water assets are considered specialised and they have few, if any, alternative uses once built. Water businesses investment decisions are irreversible. It is important that their past expenditures that are sunk be considered irrelevant for efficient decisions regarding usage and future business investment. One advantage of DORC and ODV asset valuation methodology is that the O in both is optimisation of asset base, which stipulates that only assets relevant to future demand are included in asset valuation. These assets are both optimally configured and constructed to be included in asset valuation. In particular, the DORC is the benchmark for efficient pricing and service delivery. The value of its assets is consistent with the maximum price achievable in a competitive market. Asset valuation determines water businesses performances which drives revenue requirements and prices. The asset base is usually the key determinant for water businesses, and asset valuation has major consequences for defining total costs of providing the relevant service and pricing decisions passed on to water consumers. The 207

210 key ingredient of the building block approach is RAB, which comprises of physical assets. The RAB and WACC dominate revenue calculation at least early in an asset s life. The two characteristics of asset valuation techniques are value- or market-based, and cost-based. Valuation of asset is determined largely from its cash-generating capacity under value- or market-based approaches. In contrast, the cost-based approaches relate to the value of an asset, to the cost of purchasing the asset. It also depends on the service potential embodied in the asset, either at the original cost or the original cost adjusted to reflect its current cost. This would include any cost incurred in the set-up or acquisition of the asset, along with any associated financing costs. Examples are the historical cost, the replacement cost and the DORC. The third approach, the deprival value, is a hybrid approach that considers both the valueand cost-based approaches to arrive at an asset value. The deprival value is the value of future economic benefits that would be foregone if the entity is deprived of an asset. That is, if the asset to be lost is to be replaced, it can be valued at its market value, replacement cost or reproduction cost, depending on the circumstances. An asset valuation not presently discussed in any published academic journals is the line in the sand valuation. The line in the sand valuation is the EV limb of the deprival value technique. Chapter Seven next provides an overview of the CCA and its development in Australia, followed by discussion of steps involved in asset valuation method using the ODV. 208

211 Chapter Seven: Asset Valuation Method Using the ODV 7.1 Introduction While Chapter Six covered a range of issues associated with valuation of water utility assets, this chapter continues with the discussion of asset valuations. In particular, it provides an overview of CCA and its development in Australasia. The CCA is particularly important since deprival value was a part of CCA standards in Australia, Canada, New Zealand, the United Kingdom and the United States. It uses current costs rather than historical or original costs for asset valuation, and it is currently a requirement but not mandatory for utilities businesses to account for their regulatory assets and liabilities. There are some important dates that need to be highlighted in relation to deprival value, development of the NWI and Water Pricing Principles. It was in the Statement of Accounting Practice No. 1 (SAP 1) that deprival value was initially found in In 1990 the COAG set up the SCNPM of Government Trading Enterprises, followed by Guidelines on Accounting Policy for Valuation of Assets of Government Trading Enterprises Using Current Valuation Techniques, which was proposed and issued in These guidelines suggest that non-current physical assets should be measured on deprival value or on a value to the business basis. The guidelines are developed to encourage comparability as part of its performance monitoring exercise. In 2004 an agreement by the Commonwealth and state and territory jurisdictions at the COAG meeting made NWI the blueprint for water reforms. In 2009, a draft copy of NWI Pricing Principles was released, which was endorsed by the Natural Resource Management Ministerial Council in The deprival value methodology is recommended for asset valuation for the purpose of water pricing. All three organisations the COAG, the SCNPM of Government Trading Enterprises, and the NWI recommended that assets be valued on a deprival value basis for price-setting. This chapter examines the steps involved in asset valuation method using ODV, along with discussing systems and examples of optimisation. The ODV methodology for asset valuation is based on the assessment of DORC and EV of system fixed assets. If the 209

212 DORC value of an asset is lower than its EV, DORC will be the appropriate value for the asset. However, in cases where the system was deprived of the asset, it would be replaced with the technically optimum equivalent. The basis for ODV of asset valuation is to value assets at the level at which the business can sustain, and not to reflect the cost of providing the service in an economically efficient way. System fixed assets that are uneconomic would not be replaced, but would be valued at their EV, indicating the amount a business would be willing to spend on replacement assets to provide the same level of service provided by the existing assets. 7.2 Brief overview of the CCA The concept of deprival value is well-known to both accounting theorists and accounting policymakers, and it was previously part of CCA standards in Australia, Canada, New Zealand, the United Kingdom and the United States. CCA is one of the various inflation accounting techniques that have been used as an alternative to counter problems associated with HCA. CCA is a form of accounting, stated in the current 2012 Framework for Preparation and Presentation of Financial Statements, paragraphs , in which capital maintenance is used to maintain the operating capability of a business. Capital maintenance is a concept used in accounting where capital value is determined before profit can be computed. It is based on the assumption that profit can be realised only after capital of the entity has either been restored to its original level or maintained at a predetermined level (the Institute of Chartered Accountants 2010, pp ). CCA operating profit is then calculated after charging depreciation and current cost that has been consumed. Capital maintenance is a question of high concern for water utility businesses. Underpricing water will result in erosion of the water business capital base, and the business s capacity to remain financially viable will also reduce. In contrast, over-pricing water will result in monopoly rents being extracted from consumers. Under- or over-pricing water 210

213 costs will contradict with the policy set by the NWI, paragraph 65 (2010, p. 2), which states that: In accordance with the National Competition Policy commitments, the States and Territories agree to bring into effect pricing policies for water storage and delivery in rural and urban systems that facilitate efficient water use and trade in water entitlements, including through the use of full cost recovery for water services to ensure business viability and avoid monopoly rents. Recommendations about current cost disclosures, in which current cost definition was found to be equivalent to the deprival value, are contained in the International Accounting Standards (IAS) 15 Information, reflecting the effects of changing prices (IASC, 1995, page 250, paragraph 12). In December 2003, the IASB withdrew IAS 15 as part of its Improvements Project, effective as of 1 January 2005; however, it was unable to reach an international consensus on disclosure of information reflecting to the effects of changing prices. Some of the reasons behind the failure were due to declines in the rate of inflation. That is, as inflation declines, the effects of changing prices become less important. To add to this, changes in government policy meant that tax reliefs were not given on the basis of CCA, as it was no longer required as a means of justifying price increases (Tweedie & Whittington 1997, p. 149). A similar pattern was seen in the United States where Financial Accounting Standards 33 (FAS 33), Financial Reporting and Changing Prices, was introduced in 1979, while around the same time the United Kingdom Financial Reporting Standard 7 (FAS 7) was also introduced (Whittington 1994, p. 88). In the United Kingdom, deprival value was mentioned in Financial Reporting Standard 7 (FRS 7), Statement of Standard Accounting Practice 16 (SSAP 16), and the Sandilands Report in More recently, such recognition is suggested for extension to (re)valuation of tangible fixed assets in general (ASB, 1996a/b). Based on the above discussion, it is reasonable to conclude that deprival value is accepted as a practically applicable valuation basis, which has featured in both past and current accounting standards concerned with effects of changing prices in numerous jurisdictions. 211

214 It is currently a requirement, but it is not mandatory for utility companies such as water businesses to account for their regulatory assets and liabilities. In terms of valuation of water infrastructure assets, no guidance has been provided in Australian accounting standards in regards to whether any one method is acceptable to all entities in all circumstances, or whether each of the available techniques should only be applied in certain circumstances whenever appropriate. The IASB issued its Exposure Draft, Rate-regulatory Activities, on 23 July 2009, which is applicable to valuation of water infrastructure assets, as it limits prices charged to consumers for services or products, such as water through regulations. In general, the standard is imposed by the regulator or government when the entity enjoys a monopoly or a dominant market position that gives it significant market power. The proposal, if adopted, will allow for assets and liabilities that arise from rate-regulated activities within the scope of Exposure Draft to be recognised under the IFRS. To date, the IASB (the Board) is undecided as to whether Rate-regulatory Activities should be recognised in accordance with the current Framework, or whether they should be consistent with other IFRS (IASB 2009, pp. 4 27). As of 30 January 2014, the Board issued IFRS 14 Regulatory Deferral Accounts (effective for financial reporting periods beginning on or 1 January 2016) to provide interim guidance on accounting for first-time adopters of IFRS while the Board considers comprehensive guidance on the effects of rate regulation. In practice, the appropriateness of each asset valuation method should be assessed to ensure that when applied, it will result in information relevant to the economic decisionmaking needs of the users of financial statements. 7.3 Developments of the deprival value in Australasia Statement of Accounting Practice No. 1 (SAP 1) was first issued in 1976, when deprival value concepts were first found. Later in 1983, the Australian professional bodies issued a non-mandatory recommendation, (SAP 1) Current Cost Accounting. Statement of Accounting Practice No. 1 (SAP 1) recommended that a supplementary profit and loss account and balance sheet be set up on a current cost basis, with use of deprival value or 212

215 value to business as the valuation method, and with operating capability as the capital maintenance concept. Under the concept adopted in SAP 1 Current Cost Accounting, price-setting and depreciation ensures that an organisation generates cash flows sufficient to replace its assets and maintain its physical operating capacity. At the time when Statement of Accounting Practice No. 1 (SAP 1) was first recommended but was non-mandatory, it received widespread opposition to price change in Australia, particularly among the business community, especially following the government s failure to base corporate taxation on the CCA method. Consequently, there were no favours to its adoption, and even though it continued to be a lively debate in the 1970s, it never took hold in Australian private sector financial reporting practice. Similarly, in the United Kingdom, CCA attracted subsequent interest with governmentowned enterprises. All these occurred at the same time as the Byatt Report was under discussion. It was not until July 1986 that the State of Victoria issued Accounting Policy Statement 1 (APS 1), Rate of Reporting, when Australia began to see development of CCA within the public sector. APS 1 was different from previous accounting standard Statement of Accounting Practice No. 1 (SAP 1), in that the latter is concerned with measuring a real rate of return on assets from the perspective of the finance provider, the government, rather than the business itself. A financial measure of capital maintenance was preferred to operating capability measure, which was similar to the United Kingdom s Byatt Committee approach adopted in Following the statement released in July 1986, a paper was issued by the South Australian Treasury in Existence of the concept of ODV and its association with current replacement cost concepts first began in the late 1980s and early 1990s, as a result of the Australian Government s desire to improve the measure of financial performance of governmentbusiness enterprises. Later in 1990, the COAG set up SCNPM of Government Trading Enterprises, and in 1994 Guidelines on Accounting Policy for Valuation of Assets of Government Trading Enterprises Using Current Valuation Techniques was proposed and 213

216 issued, which measured non-current physical assets on deprival value or value to business basis. The guidelines were developed for the purpose of encouraging comparability as part of the COAG performance monitoring exercise. However, the asset valuation sub-committee focused specifically on valuation of non-current physical assets (including water and sewerage). These have the greatest impact on performance indicators, but at present it is difficult to determine the most relevant asset valuation method (Steering Committee on National Performance Monitoring 1994, p. 16; Lee & Fisher 2004, pp ). These guidelines, together with the companion overview which is a synopsis of the guidelines, is to this date a primary source for accounting in government trading enterprises, for determining asset valuation principles and procedures. It is to some extent consistent with the accounting standards and other pronouncements of accounting professional bodies. More importantly, this report has the backing of state premiers and treasuries. The Australian Accounting Review (1996, p. 51) also mentioned that this report may well represent the highest reference point for financial reporting in government trading enterprises. Other organisations that support the deprival value method of asset valuation are NWI Pricing Principles, agreed in 2004 by the COAG and the SCARM (National Competition Council 1998, p. 112). Both the COAG (National Competition Council 1998, p. 112; Australian Government 2009, pp. 4 5 & 7) and the SCARM (NCC 1998, p. 112) have recommended the deprival value method for the valuation of water business assets, and conceded that deprival value should be set as the minimum of the DORC and/or the EV, which represents the present value of the revenue stream those assets will generate. Similarly, clause 6.2.3(d)(4)(iv) of the National Electricity Code (2005, p. 13) states that the Commission must have regard to the agreement made by the COAG on 19 August 1994, which stated that deprival value should be the preferred approach to valuing network assets. Deprival value, based on capital maintenance concept, is derived from a desire to improve the measure of financial performance of government-business enterprises. Even though these guidelines are not binding on state governments, they have 214

217 in practice been influential in determining accounting requirements placed by governments on statutory and government departments. In 2009, a draft copy of NWI was released, followed by endorsement of the deprival value concept by the COAG and the Ministers of the ARMCANZ in The deprival value method is recommended for asset valuations underlying the determination of water utility business revenue requirements and definitions of asset-related cost in the provision of water services. The water industry s current regulatory frameworks are based on a combination of legislation, regulatory instruments and decision-making bodies. The timeline of the development of NWI and Water Pricing Principles and its relation to the deprival value concepts are summarised in Figure 7.1 (below). 215

218 Figure 7.1: Timeline of the development of the NWI and Water Pricing Principles and its relation to the deprival value 1976: The deprival value concepts were found in Statement of Accounting Practice No. 1 (SAP 1). 1990: The COAG set up the SCNPM of Government Trading Enterprises. 1994: The COAG developed Guidelines on Accounting Policy for Valuation of Assets of Government Trading Enterprises using Current Valuation Methods. 1994: The NWI was built based on the 1994 COAG's Strategic Water Reform Framework. The deprival value was endorsed by the COAG as the preferred approach to valuing network assets for public reporting processes (performance monitoring) and ARMCANZ as a basis for water pricing; unless specific circumstances justifies another valuation method. 1998: ARMCANZ refined the COAG Water Resource Policy. The upper bound pricing is the MAR for water businesses. Price of water is set to recover all costs, including a return on capital equivalent to the WACC. 2000: Explicit guidance on the principles for water pricing were found from the Water Act Section 346 (3d)(ii) states that pricing should be consistent with government commitments under inter-governmental agreements, including the NWI. 2004: The NWI became the blueprint for water reform. It was agreed by the Commonwealth and state and territory jurisdictions at the COAG meeting. The National Water Commission has to date accredited nine states' NWI plans. 2009: Draft copy of NWI Pricing Principles released. 2010: The NWI Pricing Principles was endorsed by the Natural Resource Management Ministerial Council. Among other things, the deprival value methodology is recommended for asset valuation for charging purposes. It was established in the COAG Pricing Principles that water businesses would not engage in monopoly pricing. Asset valuation should be determined by the deprival value methodology. 216

219 In addition, Walker et al. (2000, p. 132) asserted that in Australia the deprival value accounting, a variant of the replacement cost has become the dominant public sector accounting method. In theory, IPART (1998, p. 35) and the ACCC (1998a, p. 8) conceded that deprival value was the preferred valuation method for network assets in the COAG agreement in August 1994 (p. 35; Australian Competition and Consumer Commission 1998a, p. 8). To date, only a small part of CCA practice has been adopted by the private sector, to revalue non-current assets and the requirement for downward revaluation to recoverable amount, as regulated by Australian Accounting Standard AASB 1010, Accounting for Revaluation of Non-current Assets. There is evidence that a system that best reflects the CCA has been modified from historical cost, which resembles current practice in the United Kingdom. 7.4 The O in the ODV So far in this chapter, we have discussed the general issues relating to assets and how asset valuation for water utility businesses plays a central role in the final price-setting of water. We identified that the deprival value method is the preferred method of water utility businesses asset valuation; in particular, both the COAG and the SCARM support its use. The SCARM (National Competition Council Compendium 1998, p. 112) requires that assets be valued on deprival basis for price-setting, which is the lesser of the DORC or the EV. The O in ODV and DORC, (an extension of the ODV) is a process that involves adjustment of asset valuation to reflect changes in the required deployment, modernity and the scale of assets to achieve the same level of services as supplied by the existing assets. It can range from only elimination of surplus assets to complete redesign of operations at the other (greenfield). Optimisation is consistent with deprival value philosophy, and it has been suggested that if a network owner is deprived of the assets, those assets should be optimised out. In 217

220 general, there are two types of optimisation (Ministry of Economic Development 2002, p. 112). Firstly, greenfields optimisation is the hypothetical designing and building of an entirely new, optimal collection of assets for the entity. This approach assumes that the network would be completely redesigned in such a way that it will have optimal planning horizon capacity and minimal operating cost. For example, in an airport context it involves a complete redesigned or re-engineered airport, possibly at a different location. In a water utility business, this could be the use of a completely new alignment, reduction in number of assets, or an increase in the load carrying capacity, leading to lower operating costs using the most modern technology and available equipment (PricewaterhouseCoopers 1999, p. 5; Ministry of Economic Development 2002, p. 112). The National Asset Management Steering Group (2006, p. 4.10) has previously noted some examples of greenfields optimisation. For instance, in case of water supply businesses, it can be found in the mains and service connections, which are the most significant asset groups in a water distribution network. However, the nature of the mains staged construction and possible changes in its design or other policies over the years can present greatest optimisation opportunities. PB Associates (2002, p. 11) also established that a greenfields approach to optimisation is applied, where a completely new network is configured, is the most efficient way, having no regard to the existing network design. However, the downside to this approach is that it ignores the fact that networks evolve over an extended period and may have to be adapted in response to changing patterns of supply and demand. Most regulators have therefore generally accepted an incremental (brownfields) approach to optimisation. The second type of optimisation is the lower level known as brownfields the incremental or in the ordinary course of business approach. The brownfields approach involves replacement of under-utilised and removal of redundant assets, and it retains the historical configuration of key assets. The existing assets will be replaced using fundamentally the same techniques and configurations, as it does not involve a total redesign of the way services are delivered or of processes or networks. 218

221 However, brownfields optimisation is limited to individual assets or perhaps a regional reconfiguration, which does not involve optimisation of the entire system. In the case of the airport example, this would be completed in the context of the current site only (PricewaterhouseCoopers 1999, p. 5; Ministry of Economic Development 2002, p. 112). The result of optimisation may be a reduction in size of mains due to changing acceptable pressure ranges, based on current demand plus growth allowance being less than the projected demand at the time when mains were constructed, or overall reduction in total lengths through elimination of redundant or duplicate mains along the same streets and unnecessary interconnections (National Asset Management Steering Group 2006, p. 4.13). Some examples of optimisation of water infrastructure assets are downsizing of pipe networks. Pump stations such as buildings housing electrical equipment being replaced by modern control cabinets and valued at modern cost is another example of the optimisation of pump stations. Water pumps can be made redundant because of system reconfiguration and additional storage. Table 7.1: Optimisation of water networks Activities Remove unnecessary lengths Reduce size of over capacity assets Apply optimum sizes to remaining assets Apply MEA materials to Issues/constraints - Identify abandoned mains, duplicate mains, dead ends, etc. - Ensure current consumers still served. - Ensure security of supply satisfied. - Ensure existing supply points (e.g. service reservoirs) are maintained - Any reduction should exclude nominal or planned growth, which is necessary for safety or standby purposes. - Consider standards applicable, levels of service to be delivered, and minimum sizes for efficiency. - Consider applicable standards. 219

222 remaining assets Establish optimum set of assets (National Asset Management Steering Group 2006, p. 4.13) Even though Table 7.1 (above) sets out the brownfields (incremental) optimisation of water networks, it can be applicable for other network types, such as roads. In particular, support for the concept of incremental optimisation can be found in paragraph 52 of SAP 1, which states that: In determining current cost with reference to the most appropriate modern facility, the modern facility should be of economically available technology and should not require a redesign or re-engineering of an existing of an existing entity s plant. In a related report, the Energy Regulatory Commission (2009, p. 17) claimed that the brownfields approach is widely used for DORC valuations, including electricity, gas and water infrastructure assets in most countries that have adopted the DORC or the ODV techniques. It is considered an appropriate approach because it is consistent with the deprival value concept of establishing the potential business s lowest alternative cost to replicate the network. A duplicate network would need to be built in the existing environment in the ordinary course of business, instead of a complete system redesign. However, there are cases where practitioners have supported more of a greenfields approach to optimisation, such as the Victorian Government offering substantial direct funding under a tender process outside of the provisions of the National Gas Code (because its competitive tender provisions failed to result in any successful projects completions) and pressing for reform of the National Gas Code s greenfields provisions as a longer-term solution (TXU Australia 2003, p. 9). Some of the optimisation possibilities and adjustments required are set out in Figure 7.2 below. 220

223 Figure 7.2: Degrees of optimisation Low Reproduction of existing assets surplus assets eliminated Surplus assets eliminated technological obsolescence eliminated Over-design eliminated Site re-configuration; highest brownfields Changed location High Complete or greenfields approach (Commerce Commission 2002, p. 36; Ministry of Economic Development 2002, p. 112; New Zealand Infrastructure National Asset Management Steering Group 2006, p. 3.2) 7.5 Steps involved in ODV Examples of steps involved in ODV have been adopted from other utility sectors. Practically, the ODV asset valuation method, which is applicable to valuing a system of fixed assets, consists of the following steps. Figure 7.3: Steps involved in the ODV 221

224 1. Prepare a detailed asset register 3. Existing system's fixed assets are subjected to depreciation 2. Prepare existing system fixed assets to be valued at modern equivalent asset (MEA) 4. System optimisation In Figure 7.3, the first step is to prepare a detailed asset register. It involves collection of a comprehensive asset register of system fixed assets and their configuration. All utility businesses should keep a comprehensive database for their assets, which can be used for optimisation calculation and application of EVs. Ideally, the database should be computerised to facilitate sorting and reporting in accordance with various numbers and levels of sort keys (e.g. age, asset type, physical capacity, location, quantity). The network register has to be built up from and be divided into relatively small segments to allow for adequate optimisation and application of the EVs (Ministry of Economic Development 2000, pp. 13 & 17; PB Associates 2002, p. 6). Asset registers should be checked for consistency, and therefore sample checks should be carried out to verify that quantities and ages recorded are accurate within reasonable limits. The system fixed asset register should be in a form that facilities scrutiny and can give an understanding of how it was composed (Ministry of Commerce 1999, p. 16; Ministry of Economic Development 2000, pp ). The QCA (2006) reported that its asset register containing a list of likely system fixed assets of a water utility business needs to be valued; for example, reservoir, pump station, valve and hydrant. The second step is to prepare existing system fixed assets to be economically valued at their estimated replacement cost of their MEA. That is, if a business was deprived of the use of an asset, it would not replace it with the same or equivalent asset; instead it would 222

225 replace it with a MEA that is able to provide a similar level of service (Ministry of Economic Development 2000, p. 18; PB Associates 2002, p. 6). System fixed assets are to be valued using the replacement cost of MEA that would be installed today, such that it would provide the same level of service as the assets already in place. The assets must be able to be constructed or purchased at the time of the valuation with current technology, and should have lowest lifetime cost. The MEA (including costs for all materials, labour, plant and overheads) should not reflect improvements required by legislative changes made since the assets were first built or installed, regardless of whether the existing assets have to comply with additional requirements. Such improvements would result in higher replacement costs (Ministry of Economic Development 2000, p. 18; Energy Regulatory Commission 2010, p. 20). Lower values can be applied; however, maximum values for MEAs are not to be exceeded. Specifically, the maximum replacement costs and the maximum asset lives are not to be exceeded for the purpose of assessing the DRCs of system fixed assets (Ministry of Economic Development 2000, pp. 18 & 41). Some indicators that can be used to determine what assets to select for costing when determining MEA include the asset s proven reliability of the technology, its functional compliance with modern operating requirements, and its least lifetime costs (taking account of all aspects of performance, including losses) (Ministry of Economic Development 2000, p. 18). Where there is no guidance on how to value particular major assets, the valuers should obtain cost estimates from manufacturers or suppliers of those major assets. The replacement cost and total asset life assumptions used should be explicitly identified in the valuation report (Ministry of Economic Development 2000, p. 18). After the quantities and the replacement costs of assets have been determined, costs need to be depreciated. This is the third step where the replacement cost of a system fixed asset is subject to depreciation, to reflect its remaining economic life, because an older asset, which has not been refurbished, does not have the same service potential as a new one. The existing asset s remaining life is less than the life expected from a new asset, and depreciation will effectively recognise the limited remaining life of the asset. 223

226 The straight-line method of depreciation should be used such that the depreciated value (DV) is determined as: DV = UDV x RL/TL Where, UDV = undepreciated value [i.e. replacement cost] RL = remaining life TL = total life. It can be observed from the above that both total life and remaining life need to be established for all assets (Ministry of Economic Development 2000, p. 19). The maximum total life of an MEA is not to be exceeded. However, total life lower than specified may be used and may be appropriate in some circumstances (Ministry of Economic Development 2000, p. 19). The life of each asset commences when the equipment is commissioned. The age of the asset is subtracted from its total life to determine its remaining life. The age of assets for initial ODV valuations is determined from records establishing the age, or where necessary from engineering assessments of the age. If engineering assessments have been carried out for one valuation, the age in successive valuations should be based on the same assessment. It is not allowable to reassess the time of installation of the asset unless clearly documented (Ministry of Economic Development 2000, p. 20). Grouping of assets and assessment of weighted average remaining life is acceptable in circumstances where materiality of the value of assets is not an issue, and where data of the assets were available but complex calculation could not warrant determination of age (Ministry of Economic Development 2000, p. 20). When an asset becomes redundant as part of the development of a system, it will be considered as retired early from service. However, in such instances, it should not be taken into account when assessing the remaining life of that asset. Instead, when a class of assets is routinely replaced as part of the evolution of the system before its technical life expires, it should be taken into account when assessing the total life for that class of assets (Ministry of Economic Development 2000, p. 20). 224

227 The fourth and final step is system optimisation. It is undertaken only after replacement cost and DRC of the existing network asset base have been calculated, as already done in the second and the third step (Energy Regulatory Commission 2010, p. 22). 7.6 System optimisation The MED of New Zealand (2000, pp. 14 & 21) established that system fixed assets are subject to optimisation if it is no longer in use and have excess capacity or over-design, on the basis that if the business was deprived of such assets it would just install appropriate assets necessary to provide the required type and level of service. Excess capacity assets have been defined as assets with a greater service capacity than necessary to meet the service delivery outputs within the entity s business and total asset management planning horizon, while overdesigned assets have features unnecessary for goods or services that the asset provides (National Asset Management 2007, p. 16; Energy Regulatory Commission 2009, p. 22). Optimisation should be based on the reasonable expected level of use of the asset, determined with reference to the required level of service potential or output, consistent with reasonably foreseeable future demand and the objective of minimising the whole-life costs of assets. However, both projecting growth and the issue of what represents a reasonable timeframe are problematic, as they each have a degree of subjectivity in their determination. Many infrastructure assets are long-life and have a high capital cost, and if an artificially short timeframe is adopted, it can have a distorting effect on this type of asset valuation (Energy Regulatory Commission 2009, p. 21). Optimisation will either remove any surplus assets or excess capacity from network elements, given the required level of service and network capacity, or it will make an adjustment to the valuation. Permanent excess capacity and any redundant assets or components that are not used should not be assigned a value. Overdesigned, gold-plated assets should also not be included in the replacement cost of a MEA. If an adjustment is required, the assets should be adjusted to reflect the cost of replacing the existing service potential during valuation, based on an efficient set of 225

228 MEAs to achieve the required level of service output within the entity s planning horizon (National Asset Management 2007, p. 16; Energy Regulatory Commission 2009, p. 22). It should be stressed that optimisation is not concerned with improving the system from its current state. The system does not need notional redesigning to be better than it already is, regardless of its capacity or other standards, as this would cost more. Optimisation will only result in cost reduction for valuation purposes where alternative lower cost replacement options are available. Optimisation cannot increase the value of the asset, and in no circumstances should the optimised capacity exceed the current system capacity (Ministry of Economic Development 2000, pp. 14 & 21; National Asset Management Steering Group 2006, p. 4.10; National Asset Management 2007, p. 16). The process of optimisation consists of three stages: identification of stranded assets, optimising system configuration, and optimising elements in the system (Ministry of Economic Development 2000, p. 21; Energy Regulatory Commission 2010, p. 22). Any system fixed assets that are not required to supply distribution services to existing consumers should be identified and excluded from the optimised network; such assets are known as stranded assets. These assets are value at NRV and assign a value to other businesses. System fixed assets less stranded assets will determine the DRC. Stranded assets may be valued as network spares. If this is the case, it shall be assigned a zero value for the purposes of calculating the ODV (Ministry of Economic Development 2000, p. 24; Energy Regulatory Commission 2010, pp ). When the asset is optimised to zero value, it means that it is no longer required. This asset can then only be reinstated if, for example, there is an increase in demand. The utility business s revenue must increase because it is now effectively providing additional services, as it has satisfied new demand, and the value of the investment in used and useful assets has increased (Transpower New Zealand Limited 2006, p. 32). The utility business s engineer or other suitably qualified person carries out optimisation of system configuration. This requires good current knowledge of system planning, as 226

229 optimisation is concerned with redesigning of the system configuration (Ministry of Economic Development 2000, p. 24; Energy Regulatory Commission 2010, p. 27). Next, optimisation of system configuration must be carried out by considering alternative configurations and identifying the one which satisfies relevant optimisation criteria at minimum overall replacement cost (Ministry of Economic Development 2000, p. 24; Energy Regulatory Commission 2010, p. 27). However, the process of optimisation does not include determination of MEA that would replace existing individual network components. This must be done prior to calculation of replacement cost, and for most networks components should have already been taken into account (Ministry of Economic Development 2000, p. 21; Energy Regulatory Commission 2010, p. 22). Once configuration of the system has been optimised, the elements within that system should be optimised by considering whether lower capacity, more cost-efficient elements with a lower replacement cost would be adequate. The excess capacity would be valued at nil. The engineering of the network has to be examined at this stage to confirm that the optimised asset base is not over-engineered, which may occur if parts of the existing asset base are engineered to a standard that exceeds the current practice, or if a more costefficient arrangement or configuration should be used if the existing assets were replaced (Ministry of Economic Development 2000, p. 24; Energy Regulatory Commission 2010, p. 27). The Energy Regulatory Commission 2009 (p. 22) identified over-engineering assets (based on today s standards) as either having a longer life or lower life cycle costs than the MEA. Any level of over-engineering consideration can be determined by going back to the basic principles of this valuation, which is the minimum cost of replicating the service potential embodied in the network with a MEA. To a certain extent, whether an asset is considered to be over-engineered is subjective and will change over time. If it is found that a more cost-efficient arrangement would result from applying existing engineering standards, the relevant assets will change and be replaced by a notional asset arrangement that reflects current best practice. Minimum tests are carried out in 227

230 optimising the network capacity (Ministry of Economic Development 2000, p. 24; Energy Regulatory Commission 2010, p. 27). Lastly, network equipment spares may be included in ODV as long as the spares are the same as the assets previously installed in the network. That is, the quantity of the spares to be valued in the ODV must not exceed a reasonable quantity required (Ministry of Economic Development 2000, p. 24; Energy Regulatory Commission 2010, p. 27). Figure 7.4 below summarises the steps that should be taken in carrying out optimisation and shows how they fit together. Figure 7.4: System optimisation Define demand load requirements Remove stranded assets, valued at NRV, and assign value to 'other businesses' System less stranded assets. Determine DRC Optimise configuration. Excess assets are value at NIL Useful existing and new notional assets Optimise elements. Excess capacity are valued at NIL Optimised systems are value at DRC to give the 'O' of the DORC (Ministry of Economic Development 2000, p. 26; Commerce Commission 2006, p. 16) After the optimised system has been determined, the parts in which the optimised network are different from the existing network have to be revalued by applying the cost of MEA and ensuring that these assets are depreciated to reflect the service potential of the existing assets. Assets that are notionally brought into the network from the result of optimisation should be valued at their replacement cost to determine the total replacement cost of the system fixed assets. The aggregate of individual replacement costs of the 228

231 system fixed assets in the optimised system will produce the total ORC for the network (Ministry of Economic Development 2000, p. 25; Energy Regulatory Commission 2010, p. 28). Some constraints in the process of optimisation are that the potential level of service of the optimised network should not exceed that of the existing network, and no part of the network should exceed its disclosed quality of supply criteria unless non-standard contracts with consumers exist that enhance quality of supply. The locations of points of connection to other networks should be assumed to be fixed, which can be readily bypassed and will allow a reduction in the replacement value of the utility business s assets. If this is the situation, then that fixed point of connection shall be deleted for valuation purposes, and a more cost-efficient network shall be included. The location, number of existing consumers and existing boundaries of the utility business should be assumed fixed, and the optimised network should use standard equipment, ratings and sizes to optimise construction and maintenance practices (Ministry of Economic Development 2000, p. 21; Energy Regulatory Commission 2010, p. 22). Two examples of optimisation of water assets are discussed further in Appendix Valuation of the ODV at EV The ODV methodology involves the following steps, as summarised in Figure 7.5 below: 229

232 Figure 7.5: Steps in the ODV (a) Calculation of the DORC (i) Prepare a detailed asset register (ii) Calculate the RC using modern equivalent asset (MEA) values (v) Determination of the DORC (iv) System Optimisation (iii) Assessment of depreciation (DRC) (b) Determination of the EV Determination of the ODV; ODV = minimum (DORC/ EV) Steps (a) (i) to (v) have been discussed earlier. With regard to step (b), determination of the EV, in practice the ODV is the DORC plus an EV assessment. An EV assessment is applicable to both the replacement cost and the historical cost valuations. If the DORC is less than the EV, then DORC is the appropriate ODV. That is, if the system of assets was deprived of the asset, the owner would replace it with a technically optimal equivalent. In contrast, if the EV is less than the DORC, then the EV is the appropriate measure of the ODV, since it would be replaced with an economically preferable alternative. In essence, the EV of an asset to the user is the minimum cost of replacing the asset with a more economical alternative. The asset must be capable of providing the same level of service as before. System fixed assets are valued at their EV when it would not be possible for them to earn sufficient long-run profits to provide an appropriate return on the DORC of the assets. These assets are unlikely to continue past their useful life that it will be servicing; therefore making it commercially unsustainable in the long run. This is because profit maximising revenue that they could generate is insufficient to cover all costs and allow an appropriate return to be made on DORC of the assets. Put differently, parts of the system 230

233 are incapable of generating a commercial rate of return on their DORC valuation. In this case, a detailed DORC valuation need not be undertaken, and the EV of the asset must instead be derived. Where this is relevant, the owner would not replace the asset, as to do so would be irrational. The present value of future earnings would be less than the cost of replacing the asset. The EV is the loss to the owner in this deprival situation. Therefore, when the EV of an asset is less than its DORC, the ODV is its EV (which is the maximum of the NPV of earnings or the NRV) (South Australian Centre for Economic Studies 1998, p. 8; Queensland Competitive Authority 1999, p. 9; Ministry of Economic Development 2000, pp. 15 & 27; New Zealand Institute of Economic Research 2000; p. 7; Commerce Commission 2002, p. 50; Sinclair Knight Merz 2005, p. 1; Energy Regulatory Commission 2010, p. 22). The NPV of the earnings or the NRV is the net increase or decrease in welfare, which arises from the owner being deprived of the use of assets. This NPV of earnings or the NRV can be estimated over a period of time. The ODV method and the EV option measure the extent of welfare loss on deprival. The assumption used in the EV option is that there is rational behaviour in the market, and participants are driven by profit-maximising motives. Regardless of the price of water, the water utility businesses will utilise the lowest cost production units, taking into account cost and capacity, and availability of resources and demands. Consistent with the delivery of economic efficiency, where production of the required output should be at the lowest cost possible, this market mechanism developed in place will ensure that the lowest costs of production are utilised (Transpower New Zealand Limited 2002, p. 80). The MED (2000, pp ) accurately identified the approach used to calculate EV (the maximum of present value and NRV). This involves, firstly, the selection of network segments (with reference to feeders and spurs for local distribution businesses and to point of supply), which are based on those parts of the network that apply certain general and specific criteria which are least likely to be economical. Next, having identified the segments for which the EV must be calculated, the (long-run) profit-maximising line tariffs that could be charged for consumers on the segments to be 231

234 tested would have to be determined. Using these (long-run) profit-maximising line tariffs (i.e. the maximum revenue that could be earned from each segment), the EV can be calculated either as the maximum of the present value or the NRV of each segment. The present value of an asset is the EV (i.e. at the time t = 0) of the system fixed assets in the segment. The NRV of an asset is its value at its best alternative use. It is most commonly viewed as the scrap value of the asset, and is the proceeds, less the costs of realisation. That is, if the NRV of an asset exceeds the present value of cash flows that can be obtained from the asset, the EV of the asset is its NRV. Finally, the valuation of the asset in a segment at the EV should be determined where it is less than the DORC. Figure 7.6 below illustrates the prescribed ODV method. Figure 7.6: Prescribed ODV method DORC (New Zealand Institute of Economic Research 2000; p. 17; Commerce Commission 2002, p. 56) As described in the illustration above, the first step is to prepare a detailed asset register of the existing system fixed assets and their configuration. This is the starting point for 232

235 assets valuation. Next, system fixed assets are valued at their replacement cost. This is determined by the use of MEAs that are capable of providing the same level of service as existing assets. The maximum standard replacement costs for MEAs are prescribed for majority of assets. These replacement costs are not to be exceeded, to ensure objectivity and consistency. Following the calculation of replacement costs, the existing asset ages (or its remaining asset lives) are recognised by providing for its depreciation or its DRC. To ensure objectivity and consistency, the maximum standard asset lives are prescribed and are not to be exceeded. Having calculated the asset s DRC, the next step is to optimise the distribution network. With the objective of mimicking the outcomes in a competitive market, system fixed assets are optimised some may be notionally removed from the distribution network to recognise any surplus assets or excess capacity. The required levels of service, quality of supply and network capacity are only some of the aspects that should be taken into consideration when conducting optimisation. System optimisation involves redesigning the network using MEAs, changing the configuration and size of components to meet forecast demand and growth at the end of the relevant planning period, as prescribed, varying between three and five years, and to meet existing or published minimum quality standards, at least cost. The number and location of network connections are assumed to be fixed, and optimisation can only result in reduction of the value of system fixed assets. It cannot be used to notionally improve the system network, as this would cost more. The optimisation process involves considerable engineering expertise, and typically makes reference to traditional or conventional engineering practice. Therefore, to determine the DORC, an existing asset is optimised out (excluded from valuation) and replaced by a notional asset. The notional asset is depreciated on the basis that its remaining life is equivalent to the life of the existing asset. In conclusion, to determine the EV as either the maximum of the present value or the NRV involves the selection of network segments, the determination of profit-maximising line tariffs is important, and then using the same assets to calculate the EV. 233

236 7.8 Summary The deprival value methodology is recommended for asset valuation for the purpose of water pricing. All three important water industry organisations the COAG, the SCNPM of Government Trading Enterprises and the NWI have recognised the deprival value basis for price-setting. This chapter provided an overview of CCA and its development in Australasia. CCA is deemed important, because the deprival value is a part of CCA standards in Australia, Canada, New Zealand, the United Kingdom and the United States. It is not mandatory, but it is currently a requirement for utility companies such as water businesses to account for their regulatory assets and liabilities. CCA has been used as an alternative to counter problems associated with HCA. It is one of a number of inflation accounting methods, also defined in the current 2012 Framework for the Presentation of Financial Statements, paragraphs 102 to 110, as capital maintenance used to maintain the operating capability of a business. In accounting, the capital maintenance concept is the value of capital, which is determined before the amount of profit can be computed. It is based on the assumption that capital of the entity has to be either restored to its original level or maintained at a predetermined level before profit can be realised. Calculation of CCA can be done after charging the current cost consumed and its deprecation. The issue of capital maintenance is important in relation to water businesses. If water is under-priced it will result in erosion of its capital base, which will undermine the capacity of the business to remain financially viable. On the contrary, over-pricing will result in water businesses extracting monopoly rents from consumers. More importantly, under- or over-pricing water contradicts the policy set by the NWI, paragraph 65, which notes that all states and territories agree to bring into effect pricing policies for water storage and delivery in rural and urban systems that facilitate efficient water use and trade in water entitlements, including the use of full recovery for water services to ensure business viability and avoid monopoly rents. It is reasonable to conclude that deprival value is acceptable as a practically applicable valuation method, as 234

237 it has been featured in both the past and current accounting standard with regards to accounting for the effects of changing prices in numerous jurisdictions. In terms of valuation for water infrastructure assets, there is no guidance in the Australian accounting standards as to which valuation techniques are acceptable to all entities in all circumstances, or which of the available techniques should only be applied in certain circumstances whenever appropriate. However, the IASB issued its Exposure Draft, Rate-regulatory Activities, on 23 July 2009, which is applicable to water businesses because it restricts the setting of prices that are charged to consumers for utility services or products, such as water. The standard is imposed by the regulator or government when the entity enjoys monopoly or a dominant market position. The proposal, if adopted, will allow for assets and liabilities that arise from rate-regulated activities within the scope of the Exposure Draft to be recognised under the IFRS. To date, the IASB is undecided as to whether Rate-regulatory Activities should be recognised in accordance with the current Framework, and whether they are consistent with other IFRS. At present, IFRS 14 Regulatory Deferral account balances was issued by the IASB on 30 January 2014 to provide interim guidance on accounting for regulatory deferral account balances by first-time adopters of IFRS to allow the Board to consider comprehensive guidance on accounting for the effects of rate regulation. This chapter followed on to examine the steps involved in the asset valuation method using ODV, as recommended for charging purposes. That is, it is based on assessment of the DORC and the EV of the system fixed assets. That is, if the DORC value of an asset is lower than the EV of the asset, then the DORC is the appropriate value for the asset, because if the system was deprived of the asset, it would be replaced with a technically optimum equivalent. The basis for ODV of asset valuation is to value assets at the level at which the water business can be sustained and no more, to reflect the cost of providing the service in an economically efficient manner. System fixed assets that are uneconomical would not be replaced. Such assets are valued at their EV, which is the amount a business deprived of 235

238 the assets would be willing to spend on replacement assets to provide the same level of service. In practice, the ODV applicable to valuing a system of fixed assets consists of, firstly, detailed preparations of the asset register. It involves the collection of a comprehensive asset register of the system fixed assets and their configuration. This is the same database used for the purpose of calculation of optimisation and the application of the EVs. Secondly, existing system fixed assets are valued at their MEA. That is, when a business is deprived of the use of an asset, it would replace the asset with an MEA that is able to provide a similar level of service. Thirdly, the replacement cost of a system fixed asset is subject to depreciation to reflect its remaining economic life, since an older asset that has not been refurbished does not have the same service potential as a new asset. The final step is system optimisation. This step can be undertaken only after the replacement cost and the DRC of the existing network asset base have been calculated, as discussed in the second and third step. The following chapter discusses the research methodology used for this thesis. 236

239 Chapter Eight: Research Methodology 8.1 Introduction This chapter contains the methodological framework for this research project. Research methodology entails the procedures for describing, explaining and predicting the work plan phenomena of a research project. A research methodology decision is one of the most important, as it must not only be capable of supporting the research, but should also facilitate accomplishment of the main aim of the research from beginning through to completion. This chapter is structured as follows. Section 8.1 provides an introduction to the chapter, followed by a general overview of research methodologies in section 8.2. Section 8.3 provides an overview of accounting research and how accounting research affects the world. Accounting as a social science discipline should not be studied in its own, but must take into consideration broader social and political objectives. Modern accounting research must seek to enhance the understanding of the relationship between accounting and these wider objectives. Section 8.4 explains the types of research methodologies used in accounting, including a discussion of the main research methodologies used. The first accounting research and methodologies was undertaken by Oler, Oler and Shousen. To date, with the increasing availability of externally reported financial statements and stock price information, research into financial accounting and archival research has become more common. Section 8.5 discusses the case study methodology approach that is used in this thesis. Five different types of case studies descriptive, illustrative, experimental, exploratory and explanatory are discussed. Section 8.6 looks at the specific case study methodology used in this thesis the exploratory case study approach. Simulations of different asset valuation techniques and steps involved in exploratory case study are also discussed in this section. This section provides information on the process of preparing and collecting data for this thesis. The archival data collection and quantitative (numerical) research method was used in this thesis. Information from data collections are kept on record before analysis of important issues are finalised in Chapter Nine. 237

240 8.2 Research methodology The Shorter Oxford English Dictionary defines a methodology as the science of method, or more historically as a treatise on method. It is the activity or business of choosing, reflecting upon, evaluating and justifying the techniques used in research. Without knowing the research methodology, no-one can access or judge the value of that research. Put simply, the purpose of research methodology is to describe and analyse methods, throwing light on their limitations and resources, clarifying their suppositions and consequences, and relating their potentialities to the twilight zone at the frontiers of knowledge (Kaplan 2004, p. 23). Historians and sociologists of science, such as Bocchi and Ceruti (1981), Latour (1991), and Oldroyd (1986) (cited in Quattrone 2000, pp ), have characterised the contemporary organisation of human knowledge via a twofold process of institutionalisation, known as the hierarchical Encyclopaedia as shown in Figure 8.1 below. The work in this thesis is predominately accounting-focused, although some aspects of economics are also discussed. In general, accounting researchers established a political, social and economic order for it to reach a level of importance to be recognised as a discipline. This is evident based on both the quality and quantity of accounting research output. Figure 8.1: The hierarchical organisation of the Encyclopaedia 238

241 The Universe of Knowledge Natural sciences Social sciences Sociology Physics Economics Chemistry Accounting Financial accounting Management accounting (Quattrone 2000, pp ) Figure 8.2 (below) provides the main research methodologies used in social sciences, all of which have been used by researchers in important, creative and engaging research projects. These research methodologies not only give some indication of the depth and complexity in social sciences research, but also provide a succinct introduction to the more frequently used research methodologies. Figure 8.2: List of research methodologies in social sciences 239

242 Survey Case study Experimental design Ethnography research Action research Grounded theory Content analysis Discourse analysis Documentary analysis Historical analysis Life history Phenomenology research Narrative analysis Semiotics Attitude research Image-based research Archival research Textual research Meta-analysis Feminist research (Quinlan 2011, pp. 104, 179 & 182) Ethnography research represents ways of studying cultures through methods that involve becoming highly active within that culture. That is, when a researcher wants to carry out an in-depth examination of a culture, ethnography research calls for observation in the field of the phenomenon under investigation. For example, an ethnographer can simply become part of the environment by allowing children to do what they do naturally and recording their behaviour (Zikmund, Babin, Carr & Griffin 2010, p. 139). Alternatively, action research was developed by Professor Kurt Lewin from Massachusetts Institute of Technology in He described action research as a form of research that involves collaboration between social scientists and practitioners in their attempt to understand a social problem. For example, Lewin s own action research related to the problem of minorities in the United States. Action research is used to bring about change, improvement and development in the quality of any organisation, and/or in the practice or performance of any team, group or organisation. This research is a particularly effective approach to problem-solving in organisations. One form of action research widely used in development research is the 240

243 participatory action research. In accounting, Liu and Pan (2007, pp ) used participatory action research to successfully develop an Activity-based Costing system for a large Chinese manufacturing company with no previous theory tested or generated. Grounded theory methodology is an inductive investigation where specific focus is on building theory from data. The researcher poses information provided by respondents or taken from historical records. The researcher questions one's self, and the responses are repeatedly questioned to derive deeper explanations. Questions can also be applied to visuals in an effort to develop the theory (Zikmund, Babin, Carr and Griffin 2010, p. 140). Phenomenology research methodology, in contrast, is a philosophical approach used in the social sciences to experience live situations (e.g. a worker in a factory, the CEO of a company, or an undergraduate business student) from a first-person point of view. Narrative research or analysis is a methodology used to gather and analyse narratives. Often narratives data or personal experience stories narrated to the researcher are gathered and analysed. For example, narrative was developed around Lara Croft, a fictional character from Square Enix video game series Tomb Raider, and her image was used to promote diverse products from video games, magazines, credit cards to soft drinks. Historical research or analysis is a method that explores and analyses the history of certain phenomenon. For instance, useful lessons can be learned from studying the history of companies such as Apple Computer Inc. or the Microsoft Corporation. To add to this, life history methodology is used to compile life histories of different people in order to understand the changes that have occurred in their lives. It can also be used to compile the life history of changes that have occurred in the life of a company. Other than observing people and physical objects, researchers may use content analysis to obtain data by observing and analysing the contents or messages of advertisements, newspaper articles, television programs, letters and so on. For example, content analysis can be used to explore the information content of television commercials directed at children, the company images portrayed in adverts or other aspects of advertising. 241

244 Documentary analysis or research is a methodology that involves the systematic analysis of data in the form of documents or data drawn from written documents such as books, papers, magazines, notices, letters and records. Meta-analysis is a quantitative research analysis of the amalgamation of previously existing research data sets. This methodology involves analysis of quantitative data sets from previously conducted research projects, in combination. However, meta-analysis is dependent upon the validity of existing data sets, so the possibility of error is large when using this methodology. 8.3 Overview of accounting research Accounting is known as the language of business. Oler, Oler and Shousen (2009, p. 3) claimed that accounting research is a literature that not only draws from but also adds to a larger body of work dealing primarily with businesses, as well as their interactions with society at large through capital markets. One of the most important arguments regarding accounting research was put forward by Hopper and Powell (1985, p. 450), that accounting as a social science should no longer be studied in a mode that is divorced from its social context and that ignores the influence of wider social and political objectives. They recommended a research program that seeks to enhance understanding of the relationship between accounting and these wider objectives. Their point of view is especially relevant in this thesis, given the key role accounting valuation of assets has on the determination of regulated prices, which in turn has a number of economic and social implications. Hopwood (1983, p. 303) noted that many researchers from other disciplines had begun identifying a variety of interesting research avenues in the accounting domain. For instance, sociologists have started recognising the research potential offered by the accounting craft. Questions have been asked about how accounting might be related to the more general elaboration of calculative practices in modern society. There are many ways in which accounting has provided a powerful calculus for forging a new visibility which 242

245 can facilitate specific modes of control within the business enterprise in particular, and more legitimised functions of the accounting craft. As with any other research, accounting research in general plays an essential part in the creation of new knowledge. It can make a difference in the world as it affects the accounting standard setters, which in turn affect the business practice, usually at the level of decision-makers. Mentor researchers thinking can then change the world through consulting, professional service, teaching and so on. In terms of this research project, as accounting is now known as the language of business, accounting information is of paramount importance, both to accountants and academics. For example, research into asset valuations used by water utility regulators. The two broad areas in accounting are financial accounting and management accounting. Coyne, Summers, Williams and Wood (2010, p. 7) identified the six broad areas of research in financial and management accounting, as shown in Figure 8.3 below. They are accounting information systems (AIS), auditing, financial accounting, managerial accounting, tax, and other. Figure 8.3: Six broad areas of research in accounting Accounting information systems Six broad areas of research in accounting Auditing Financial accounting Managerial Tax Other (Coyne, Summers, Williams & Wood 2010, p. 7) 243

246 The current state of accounting research is characterised as research into the effect of economics events on the process of summarising, analysing, verifying and reporting financial information, and the effect this reported information has on economic events. Accounting research has shifted over time. In the pre-1960s, accounting research was mostly normative; that is, the correct accounting application was argued, or put differently, accounting research was based on what it should be. Normative research seeks to derive and prescribe accounting standards. Over time, it has increasingly taken citations, particularly from economics and finance disciplines, suggesting that it is drawing closer to these disciplines. Post-1960s, accounting research moved into positive research; that is, examining what is rather than what should be, and seeking to explain and predict actual accounting practices. Positive research became more dominant because it can embrace the consequences of accounting in wider institutional settings. Accounting research became more focused on the effects of accounting information on economics events (Granof & Zeff 2008, p. A34; Oler, Oler & Skousen 2009, pp. 7 & 10 11). A landmark paper was written and published by Watts and Zimmerman (1978, pp ), who articulated how positive research can play a role in setting accounting standards, an area where one would expect normative research to naturally dominate. It was this paper which helped justify the growing output of positive research from academics. Researchers such as Plumlee et al. (2005, pp. 1 63), and Tuttle and Dillard (2007, pp ) have consistently argued that financial accounting is increasingly dominant in accounting research. The research scope in accounting is broad, the evidence of which can be found from the literature, ranging from countless papers and books to journals and so on. 8.4 Accounting research methodologies A methodology needs to be selected by the researcher in order to determine how the research is to be conducted. The three main research methodologies in accounting are archival, analytical and experimental design. The other accounting methodologies include case study, field study, grounded theory, review, survey, theoretical and normative. Most surveys are quantitative research projects with some qualitative elements. The type of 244

247 data collection methods used in surveys are questionnaires or scales, which are an effective method to use in engaging with large research populations. If the population is geographically scattered, a questionnaire can be posted or mailed, or made available online. It is quite common that the internet is used in survey research. As its name suggests, experimental is the methodology used when conducting experiments. Experimental design research is best implemented when the designed experiments are properly set up in laboratories or laboratory conditions. In general, due to the difficulty in controlling all the different variables in social science situations, and the phenomena and the difficulty of replicating the social world or in the study of social phenomena, true experiments are rarely conducted in business research or in social science research. The defining feature of the experimental methodology in accounting is that data from human subjects are assigned to multiple treatment groups, unlike survey methodology which has no treatment group. It can include analysing both economic and behavioural factors. The researcher manipulates one or more variables with subjects that are assigned randomly to various groups. It is possible for the researcher to select different populations to manipulate a variable. If this is the case, these would be included as experimental in nature. For example, participants of different experience levels were selected for this research thesis. Archival research is research carried out on the content of archives. Archives are stored records and/or documents of a company or a business, the size of which may be very small to very extensive. The website of The National Archive of the United Kingdom defines archives as documents in any medium that have been created by an individual, family, business or organisation during its existence and have been chosen to be kept permanently because they are considered to be of continuing value. In contrast with experimental methodology, archival research requires that in a natural setting, data are produced as a result of the researcher s conducts of the contents of that archival research (Quinlan 2011, p. 187). Archival research includes studies in which the researchers collect data that has objective amounts such as net income, sales and fees. For example, fundamental analysis of 245

248 accounting numbers to the content analysis of texts and narratives such as accounting standards and other regulation, as long as the research is restricted to analysis only. An example of archival research methodology in finance is the use of data from historical market information such as stock prices, bonds or commodity prices. Archival research methodology is also known as capital markets research. Field or case study research methodology is preoccupied with the study of the role and function of accounting in its natural context. The term case study usually implies research which is confined to a single unit of analysis. On the other hand, fieldwork encompasses more general studies of social activity. Non-empirical or analytical research methodology, unlike other methodologies discussed, is not guided by research experience or experiment. It comprises theory construction and evaluation using formalised, mathematical models to predict, explain or give substance to theory. Examples include financial modelling, formal game theory and agency models in accounting areas such as auditing, financial reporting and disclosure. Fulbier and Sellhorn (2008, pp. 1 37, cited in Gruszczynski 2009, pp. 6 7) compiled a list of research methodology in accounting based on accounting papers presented to the annual congresses of European Accounting Association (EEA) in 2000 and Notably, as presented in Figure 8.4 below, 70 per cent of papers presented to the EAA Congress in 2005 were classified into archival (empirical) research methodology, which made it the most popular research methodology in accounting. The other category captures researchers who adopted multiple methodologies, which includes methodologies not easily assigned to previous categories. The ambiguous category includes those research methodologies that are not made clear in the abstract. Oler, Oler and Shousen s study (2009, pp. 1 72) is considered the first research paper about accounting research and methodologies, and their findings have arrived at very similar conclusions. For instance, the relative proportion of citations drawn from prior accounting papers appears to be borrowed from economics and finance, and research in financial accounting and archival methodology is becoming increasingly dominant. In noting this, the trend towards more financial accounting and archival research is 246

249 consistent with a significant number of events beginning with the Journal of Accounting Research in 1963 and the publication of Ball and Brown (1968, pp ) in This is aided by an increasing availability of externally reported financial statement and stock price information. However, there was no corresponding increase in the availability of other information; for example, internal accounting information to support managerial research. These trends of increasing availability of externally reported financial statement and stock price information are linked to the conscious decision of many researchers to pursue a positive research paradigm following social sciences. 247

250 Figure 8.4 Research methodologies in accounting papers presented to EAA Annual Congress, 2000 and Archival % Experimental % Field/ case study % Survey % Analytical % Theory % Other % Ambiguous % Archival % Experimental % 2 0 Field/ case study % 3 1 Survey % 7 6 Analytical % 0 1 Theory % 7 6 Other % Ambiguous %

251 8.5 The case study methodology to this thesis The case study is one of the many methodologies used in social sciences research. Yin (2003, p. 1) asserted that case study is the preferred methodology when the research focus is about a contemporary phenomenon, within some real-life context such as a project or program in an evaluation study. It is used in many situations to contribute to knowledge of individual, organisational, social, political or other related phenomena. It can be used when how or why (illustrating why something was done or came to be, or when and why something works) questions are posted, and when the researcher has little control over the events. One of the strengths of case study methodology is that it is not linked to a particular type of evidence or method of data collection (Olalere 2011, p. 24). Cooper and Morgan (2008, pp ) explained that case study research in accounting can be a valuable tool to understand complex phenomena. It has multiple benefits such as providing valuable insights that open up new and promising areas. As such, it can be used to test existing theory and generate a new one. Cooper and Morgan demonstrated that case study research in accounting can be useful to accounting practitioners by helping them understand the applicability of specific accounting innovations in complex contexts, re-assessing their conceptualisations of problems, and learning how to be more skilled in using rules. Yin (1989, pp ) suggested that for a case study to be complete, the boundaries of the case, that is the distinction between phenomenon and context, are given explicit attention. The documentation demonstrates not only that the researcher expended exhaustive effort in collecting the relevant evidence, but also artifactual conditions are absent (not because they researcher ran out of time). The case study methodology has been applied to this thesis. Rather than using samples and following a rigid protocol to examine a limited number of variables, the case study methodology involves an in-depth study of a single or multiple instance/s or event/s that is a case. The case study methodology provides a systematic way of not only looking at events, but also collecting data, analysing information, and reporting the results. The researcher gains a sharpened understanding of why the event happened as it did, and discovers what might become important to study more extensively in future research. Case study methodology leads itself to both generating and testing hypotheses (Flyvbjerg 249

252 2006, pp ). It is a systematic and organised way to produce information about a topic, as well as the product of this approach. It is an in-depth, contextually informed examination of specific organisations or events that explicitly address theory (Cooper & Morgan 2008, p. 160). All case study methodologies exhibit the same compelling feature; that is, the desire to derive a(n) up-close or otherwise in-depth understanding of a single or small number of cases set in their real-world contexts (Bromley 1986, p. 1, cited in Yin 2012, p. 4). The main aim of the case study methodology is to produce both an invaluable and deep understanding of the insightful appreciation of the case(s), with the end result of achieving new learning about the real-world behaviour and its meaning. The history of case study methodology can be traced to Europe, predominantly France. Well documented in the United States from the early 1900s until 1935, the case study research methodology was mostly associated with the University of Chicago Department of Sociology, where the school was pre-eminent in the field and the source of a great deal of literature (Tellis 1997, p. 2). Yin noted that case studies should not be confused with qualitative research, and pointed out that the case study methodology can be based on any mix of quantitative and qualitative evidence (Yin 2014, p. 19). Accounting practitioners find the how questions to be particularly important; for example, it is valuable in describing the details of how new accounting and auditing innovations were created. Table 8.1: Relevant situations for different research methodologies (Source: COSMOS Corporation) Research Form of research Requires control Focuses on methodology question of behavioural contemporary events? events? Case Study Who, what, where, how many, how much? No Yes Experimental How, why? Yes Yes Archival Who, what, where, how many, how much? No Yes/No 250

253 Research Form of research Requires control Focuses on methodology question of behavioural contemporary events? events? Case study How, why? No Yes (Yin 2003, p. 5) Table 8.1 above shows the main research methodologies used in accounting. It displays the three conditions of when to use each methodology, which are: (a) the type of research question posed; (b) the extent of control a researcher has over the actual behavioural events; and (c) the degree of focus on contemporary as compared to historical events. For instance, the case study research methodology is used when a how or a why question is being asked about a contemporary set of events over which the investigator has little or no control. The case study research methodology can be used in a variety of ways by accounting researchers. Researchers such as Stake (1995) and Yin (2003) identified at least six sources of evidence (documents, archival records, interviews, direct observation, participant observation and physical artefacts) used in case study methodology. The five different types of accounting case studies are shown in Figure 8.6 below. Figure 8.6: Types of accounting case studies 251

254 3. Experimental case study The first type of case study is descriptive, which is one of the most common. It presents a complete description of a phenomenon within its context (Yin 2003, p. 5). It begins with a descriptive theory that covers the depth and scope of the case under study or whether the researcher could face the possibility that problems will occur during the project. The descriptive case studies imply that this is a formation of hypotheses of cause-effect relationships. The selection of cases and the units of analysis are developed in the same manner as other cases. Descriptive case studies describe accounting systems, including the techniques and procedures used in real-world practice. Such a study can be beneficial to explore the use of traditional or modern accounting techniques and practices. Professional accounting bodies have often supported this methodology, as it offers the possibility of determining best practice, sometimes conceived as the most common practice, and other times as the practice adopted by successful companies. The second type of case study is illustrative, which attempts to illustrate new and possibly innovative practices developed by particular companies. This type of case study provides an illustration of what has been achieved in practice. The illustrative case study can provide examples for researchers to learn from these innovative companies (Ryan, Scapens & Thoebald 2002, p. 143). The third type of case study is the experimental case study, which consists of procedures and techniques developed from existing theoretical perspectives, using normative 252

255 reasoning, and is intended to indicate what should be done in practice. This type of case study includes new accounting procedures and techniques intended to be helpful to accounting practitioners. The fourth type of case study is the exploratory case study, one which uses fieldwork and the data collected, aimed at defining the questions and hypotheses of a subsequent study, or at determining the feasibility of the desired research procedures. Unlike other case study, the exploratory case study has been considered a prelude ( exploratory ) to some social research. However, the framework of the study must be created first. Fieldwork and data collection must be undertaken before the research question and hypotheses are defined, and it is useful to use pilot projects to determine the final protocols. Based on the outcome of the pilot study survey, questions may be added (Yin 2003, pp. 5 6). However, the exploratory case study is often perceived as sloppy, since the researchers may follow intuitive paths. The best part of this methodology is that the research goal may justifiably be to discover theory, by others directly observing a social phenomenon in its raw form (Glaser & Strauss 1967, cited in Yin 2003, p. 6). On the other hand, the exploratory case study may be used to explore reasons for particular accounting practices. It enables the researcher to generate hypotheses about the reasons for particular practices that can be subsequently tested in large-scale studies. This case study methodology represents a preliminary investigation, and is intended to generate ideas and hypotheses for rigorous empirical testing at a later stage. The fifth type of case study is the explanatory case study that focuses on a specific case. It attempts to explain the reasons for observed accounting practices, and it uses theory to understand and explain the specific, rather than to produce generalisations. This theory is used to enable researchers to provide convincing explanations of the observed practices. However, it may be necessary to modify or develop new theory, which can be used in other case studies. The explanatory case study type of research is used to generate theories that can provide good explanation of the case being studied. 8.6 The exploratory case study methodology to this thesis Figure 8.7: The environment and relationship between research thesis elements 253

256 Researcher Idea: The Valuation of Assets and its Impact on Water Utility Pricing in Australia Methodology: Exploratory Case Study Method: Quatitative and Archival Data Collection Figure 8.7 shows the environment and relationship between elements of this research thesis. In any research thesis there are six methods of collecting data (i.e. survey questionnaire, interview survey, test and measurement, direct observation/participation, focus group/seminars, and archival). The exploratory case study research methodology was applied to this thesis, which was used to test the existing theories, such as the building block approach from which water prices are determined, the upper- and lowerbound pricing principles described in economics, and the NWI Pricing Principles. The specific data collection used in this thesis is archival (secondary data) and quantitative (numerical) methodology. Initially, certain major aspects of the case study (e.g. research questions, hypothesis of the study, data collection methods and accessibility to the data) appeared uncertain, and these issues needed to be investigated. The hypothesis of this thesis is to test if there is a direct relationship between investment in water assets, pricing and the RAB. After the investigation, the pilot and exploratory phase was considered and completed. The researcher started the case study from scratch, developed a research methodology, found a set of information from various sources, and collected a fresh set of data. This pilot study pointed to the need for some experimental research methodology or some methodology different from a case study. It showed that sufficient evidence and alternative perspectives needed to be considered for the research to be complete. 254

257 The case study methodology followed the design suggested by researcher Yin (2003), and was applied as shown in Figure 8.8 below. Figure 8.8: Case study methodology design, as identified by Yin (2003) 1. Determine and define the research question 6. Prepare report 2. Select the cases 5. Evaluate and analyse data 3. Determine data gathering and analysis techniques 4. Collect data in field Step 1: Determine and define the hypothesis of the thesis This is the first step where the researcher establishes a firm focus to which they can refer to over the course of the project of a complex phenomenon. The focus of the study was established by forming questions about the situation or problem to be studied, and hence the purpose of this study was determined. In any case study, the research object is often a program, an entity, a person or a group of people, and as each object is likely to be connected to political, social, historical and personal issues, these provide a wide range of possibilities for questions (Soy 1997). The object of the case study is investigated in depth using a variety of data gathering methods to produce evidence, leading to an understanding of the case and in answer to the research questions. In general, any case study research should be able to answer either one or more questions that begin with how or why. These questions are limited to a number of events or conditions and their inter-relationships (Soy 1997). In Chapter Three of this thesis, the 255

258 researcher conducted a literature review to assist in targeting and formulating the questions. This review established and discussed academic researches previously conducted, leading to refined and insightful questions about the problem. The review pinpointed the evidence that helped determine the methods of analysis to be used in this study (Soy 1997). The researcher used both the literature review and industry reports to define the following listed research questions listed on the impact of rival techniques of asset valuation in water utility pricing in Australia. In general, utility providers and businesses use a variety of asset valuation techniques that result in different valuation figures in the construction of the company s balance sheet. From the context of water utility pricing, this thesis explores the use of two main rival asset valuation techniques, the DORC and the EV. The researcher was primarily interested in determining whether the rate base asset valuations used in Australia, based on water prices and determined using the building block approach, led to different levels of water prices and the degree to which different asset valuation techniques affected the pricing. Since water businesses are subjected to price regulations, a notional cost in relation to the business s existing assets is reflected in the price that it is allowed to charge. The process of asset valuations and accounting for water providers and businesses in order to determine the correct price of water is known to be particularly challenging. The researcher set out to explore three basic areas in this thesis, which are as follows: if different asset valuation techniques affect the behaviour of consumers and investors if these asset valuation techniques provide efficiency for water businesses to finance their activities if different asset valuation techniques prevent monopoly rents. The purpose of this thesis is to reveal to academics and practitioners whether the DORC or EV principles are well suited for tariff regulation, and whether the financial models can be transported successfully to other price-setting and financial modelling applications, either in the public or private sector, or both. 256

259 Step 2: Select the cases In this design phase, either a single or multiple real-life case study research needs to be examined in depth. If multiple cases are used, each case can be treated as a single case. Each case remains as a single case, but these individual conclusions can be used as information that contributes to the study as a whole. For a case study to be exemplary, cases must be carefully selected, and the choices available must be examined from among the many research tools available (Soy 1997). The researcher must determine either to study cases that are considered typical, or cases that are unique in some way. Cases may be selected to represent a variety of geographical regions, size parameters or other parameters. It may be useful in this step to repeatedly refer back to the purpose of the study as part of the selection process. In doing so, attention can be focused on where to look for cases and evidence that will satisfy the purpose and provide answers to the research questions posted. The key element in this step is the selection of either a single or multiple cases. A case study research methodology may involve more than one unit of embedded analysis. It may involve study of a single industry and a firm participating in that industry. If relevant, this case study involves two levels of analysis and increases the complexity and amount of data to be gathered and analysed (Soy 1997). In this thesis, multiple (three) cases were used. The first one was discussed in Chapter Four, where case studies were used to provide an overview of the industry governance, structure and the broad area of ownership for urban water services in major Australian cities. The second one was in Chapter Five, where case studies were used to discuss existing regulations and pricing structures in water and wastewater sectors in Australia s major capital cities. The third one is in Chapter Nine, where case studies of major Australian cities will be used to link the RAB and the regulator s pricing decision. 257

260 Step 3: Determine data gathering and analysis techniques The case study research methodology has the advantage that it involves use of multiple sources, tools and techniques (e.g. documents, archival records, surveys, interviews, direct observation, participant observation and physical artefacts) in the data gathering process. In this step, evidence needs to be gathered and the techniques used with the data for analysis need to be determined in advance. The data gathered is generally largely qualitative, but can also be quantitative. The researcher must ensure that the designated data gathering tools are chosen and be used systematically and consistently in collecting the evidence (Soy 1997). In this design step, the researcher must ensure that the study is well constructed and has high validity and reliability, so that its measurement provides consistent results. The researcher gathered data from regulators and water utility businesses reports, and the variables that make up the calculations for the rate base formula were collected so that an in-depth simulation could be conducted. This procedure is well documented, multiplied repeated with the same results, and cross-checked with the literature review to ensure that the methodology and design are exemplary. The data gathered has been used for the regression analysis, specifically the Least Squares Regression Method in Chapter Nine, to test the relationships between the dependent variable, capital expenditure and independent variables, asset valuation techniques, length of pipes connecting residential properties water supply, and the amount of population connected to urban water services. Regression analysis was used to test if a relationship exists between asset valuation techniques, prices, profitability and investment levels (dependent variable) in the industry, as well as the long-term viability of the industry. Step 4: Collect data in field This researcher comprehensively and systematically collected and stored various report sources to be used as evidence. The formats were referenced and sorted so that lines of 258

261 inquiry and patterns could be uncovered. The object of the case study was carefully observed, and causal factors associated with the observed phenomenon are identified (Soy 1997). As the study progresses, the object of the study is renegotiated and data collection is updated whenever necessary. This case study research is flexible, as it is not only documented systematically, but changes are made whenever required (Soy 1997). Archival (secondary) and quantitative (numerical) methodology is the specific data collection used in this research thesis. In accounting research, Oler, Oler and Shousen (2009, p. 6) pointed out that the archival data collection method is the most common technique. The researcher has no contact with the research participants and the data used are collected by previous researchers, water regulators, providers and businesses. Significant time and cost is saved, because the focus is on data analysis as in Chapter Nine. In step 4, the researcher enters data such as RAB, return on capital, return of capital, investment, length of pipes and number of residents connected to water pipes data into a database, and other data are physically stored. The researcher documents, classifies and cross-references all the evidence to be efficiently recalled for sorting and examination over the course of the thesis (Soy 1997). However, due to lack of experience and comparison of asset valuation techniques in water businesses, simulation of different asset valuation techniques were taken from electricity and gas companies. In doing so, these asset valuation techniques closely match the real-world results. The relationship between the issue of whether the price of water will be impacted by the use of two rival asset valuation techniques, the DORC and EV valuation, and the evidence used to prove this was maintained. Step 5: Evaluate and analyse data The raw data were examined by the researcher using many interpretations, so that links between the research object and the outcomes with reference to the original research questions could be found. Throughout this evaluation and analysis step, new opportunities and insights are explored (Soy 1997). One of the advantages of case study research is that multiple data collection methods and analysing techniques were used. This allows the 259

262 researcher not only the opportunity to triangulate data to strengthen the research findings and to reach the conclusions, but the researcher is also able to move beyond initial impressions to improve the likelihood of accurate and reliable findings. In this step, the researcher categorises, tabulates and recombines the data to address the initial proposition or purpose of the study. Facts are cross-checked and any discrepancies in accounts were noted. Throughout this step, additional data are gathered to verify key observations and to double-check a fact. The researcher uses quantitative data that has been collected to corroborate and support the qualitative data. These data will be useful for understanding the rationale and theory underlying relationships. Specific techniques used include placing information into arrays, creating matrices of categories, and creating flow charts and diagrams (Soy 1997). Step 6: Prepare the report The final step is to prepare the report; that is, to analyse and interpret the data by attempting to explain the meaning of what it is that the researcher sees in the data, as explained in Chapter Nine. The case study report should transform complex issues into ones that can be understood, allowing the reader to question and examine the report and reach an understanding, independent of the researcher. It is important that particular attention is given to displaying sufficient evidence in order to gain the reader s confidence, and that all avenues have been explored. The boundaries of the case study are discussed and attention is also given to conflicting propositions. In the following Chapter Nine, the researcher further interpreted the data, stating what the data shows and the researcher s interpretation of it, and reaching conclusions based on this. These are considered in detail in the final chapter, Chapter Ten. The conclusions that the researcher draws, based on the analysis and findings from the data in Chapter Nine, add up substantially to contribute to the overall conclusions in Chapter Ten. 260

263 8.7 Summary One of the most important decisions to be made in any research project is the methodology framework. The research methodology used must be able to not only support the research, but also facilitate the accomplishment of the main aim of the research from the beginning through to its completion. The methodology is the activity or business of choosing, reflecting upon, evaluating and justifying the methods used in research. No-one is able to assess or judge the value of that piece of research without knowing the research methodology used. The contemporary organisation of human knowledge can be explained via a twofold process of institutionalisation known as the hierarchical Encyclopaedia. Accounting is an academic subject placed below economics. This thesis is predominately accounting focused; however, some aspects of economics also remain important. In social sciences, researchers use many different research methodologies to conduct important, creative and engaging research projects. The types of research methodologies in social sciences include survey, case study, experimental design, ethnography, action research, grounded theory, content analysis and discourse analysis. They provide an introduction to the frequently used social sciences research methodologies, and provide some indication of the depth and complexity in social sciences research. In general, accounting research plays an essential part in the creation of new knowledge, as it can influence the accounting standard setters, which will in turn affect the business practice and the decision-makers. Financial and management accounting are the two broad areas in accounting, and the other six broad areas of accounting research are AIS, auditing, financial accounting, managerial accounting, tax, and other. AIS relate to the systems and the users of systems that collect, store and generate accounting information. Financial accounting relates to financial markets and decision-making based on financial accounting information, while managerial accounting examines decision-making within an enterprise, incentives, and allocation of resources within an enterprise, as well as budgeting and compensation. Tax relates to all issues regarding tax; that is, taxpayer decision-making, tax allocations, tax computations and so on. 261

264 Accounting research was mostly normative in the pre-1960s. Normative accounting is based on what it should be; under which, accounting seeks to derive and prescribe accounting standards. Over time, accounting research has shifted and it has increasingly taken citations from economics and finance disciplines, suggesting that it is drawing closer to them. Accounting research moved into positive research post-1960s, examining what is rather than what should be. In positive research, accounting seeks to explain and predict the actual accounting practices. A landmark paper was written and published by Watts and Zimmerman, where they not only articulated how positive research can play a role in setting accounting standards, an area where normative research naturally dominates, but that is also helped justify the growing output of positive research from academics. The three main accounting research methodologies are archival, analytical and experimental design. In archival research, the researcher gathers data by asking subjects to perform tasks in a controlled setting. In a natural setting, archival research requires that data are produced as a result of the researcher s initial action. Analytical or non-empirical research methodology comprises of theory construction and evaluations using formalised, mathematical models to predict, explain or give substance to theory; it is not guided by research experience or experiment. Experimental design methodology is used when conducting research experiments. The research methodology used in this thesis is the case study methodology, which provides a systematic way of looking at events. In case study methodology, data are collected, information is analysed and results are reported. The compelling feature of all case study research is the desire to derive a(n) up-close or otherwise in-depth understanding of a single or small number of cases set in their real-world contexts. The case study methodology produces not only an invaluable but also deep understanding of the insightful appreciation of the case(s), with the end result of achieving new learning about the real-world behaviour and its meaning. The exploratory case study research methodology was applied in this thesis. It tests existing theories, such as the building block approach, based on which water prices are determined the upper- and lower-bound pricing principles. The data collection method used in this thesis is the archival (secondary data) and quantitative (numerical) 262

265 methodology. The hypothesis of the thesis is that there is a direct relationship between investment in water assets, pricing and the RAB. The case study methodology used in this thesis followed the design (six steps) described by researcher Yin. In the first step, the researcher establishes a firm focus to which they can refer to over the course of the project on a complex phenomenon. This researcher set out to find three basics findings from this thesis: (i) whether different asset valuations affect the behaviour of consumers and investors; (ii) whether the asset valuation techniques provide efficiency for water businesses to finance their activities; and (iii) whether different asset valuation techniques can prevent monopoly rents. In the second step, the researcher selects either a single or multiple cases. In this thesis, multiple (three) cases were used. The first case study was in Chapter Four, the second in Chapter Five, and the third is in Chapter Nine. In the third step, this researcher gathered data from regulators and water utility businesses reports, and variables that make up the calculations for the rate base formula. This procedure was repeated with the same results over and over again, and cross-checked with the literature review to ensure that the methodology and design are exemplary. In the fourth step, the researcher collects and enters data into a database, and other data are physically stored. Next is the fifth step where the researcher categorises, tabulates and recombines the data to address the initial propositions or purpose of the study. Facts are cross-checked and any discrepancies in the accounts noted. Quantitative data are collected to collaborate and support the qualitative data. The final step is step six, where the report on findings is presented. The report transforms complex issues into those that can be understood, allowing the reader to question and examine the report and reach an understanding, independent of the researcher. In this thesis, this is done in Chapter Nine, where the researcher analysed and interpreted the data to explain the meaning of what it is they observed in the data, and what they believed this means to draw conclusions from. The next chapter shows results and discussions of different asset valuation techniques used by water utility businesses and the impact on pricing of water. 263

266 Chapter Nine: Results and Discussions 9.1 Introduction Chapter Eight provided a general overview of the research methodology, followed by an overview of the research methodology used in accounting. The exploratory case study methodology used in this thesis was also discussed in the previous chapter, along with information from data collections that is kept on record. In this chapter, detailed information of the process of preparing and collecting data for this thesis is provided, before important issues are analysed and finalised. Chapter Nine is structured as follows. Section 9.2 presents a comparison of seven asset valuation techniques. These comparisons are based on information from data collections kept on record as per Chapter Eight. Data was taken from both the electricity and gas industries, while various asset valuation techniques are based on random events called simulation from electricity and gas companies. These techniques closely match the realworld results. However, a comparison of different asset valuation techniques for water businesses is limited due to fact that the deprival value has been recommended as the preferred valuation method for the purpose of charging water prices. Also, there is a lack of competition in the water industry; customers do not have the option of changing and accessing other water providers. In addition, the experience with the use of the deprival value, including the DORC, is less compared with other utilities such as electricity, gas and rail; hence the comparison is limited. This is followed by justifications for the findings of these techniques in section 9.3. The ODV asset valuation method is the preferred approach of valuing network assets, as endorsed by the COAG. It is important to note that deprival value is not the DORC. The DORC is the replacement cost and the absolute upper limit of the deprival value concept (Bonbright 1937, p. 1139; Solomon 1971, p. 111; Bertram 2000, pp ; King 2000, p. 2; 2001, pp ). DORC is also the upper-bound pricing recommended in the COAG Water Resource Pricing Principles. The lower side of the deprival value is the EV, specifically the NRV, which is the lower-bound pricing in the COAG Water Resource Pricing Principles. An asset cannot be of less worth to its owner than its resale value. That 264

267 is, the loss that the owner would sustain if they were deprived of the asset cannot be greater than the cost of replacing the asset. Section 9.4 presents case studies of the RAB and its relation to the pricing of water in major Australian cities, while section 9.5 summarises the current institutional structure of water and wastewater provision in major Australian cities. Section 9.6 reviews water pricing principles as outlined by the NWI, the national blueprint for water reform. Section 9.7 presents a summary of asset valuation techniques used by water utilities in major Australian jurisdictions, and based on these discussions, section 9.8 concludes by looking at whether the price of water is too high or low. 9.2 Comparison of pricing-based asset valuation techniques Four asset valuation techniques used by two gas companies, that is AGL Gas Networks Limited (AGLGN) in NSW and ActewAGL in Canberra, are shown in Tables 9.1 and 9.2 below. Table 9.1: Asset values at 1 July 1996 using four different asset valuation techniques (DAC, DIHC, DORC and ODV asset valuation techniques) in ($ million) Capital assets (system and AGLGN (original proposal) Final decision (June 2000) non-system assets) DAC DIHC DORC ODV (Independent Pricing and Regulatory Tribunal 2000, p. 8 & 79) 265

268 Table 9.2: Asset values using four different asset valuation techniques (DAC, DIHC, DORC and ODV) in ($ million) Capital assets (system and ActewAGL (original Final decision (October 2000) non-system assets) proposal) DAC (agreed) DIHC DORC ODV 245 Correct to submission; essentially equal to DORC (Independent Competition and Regulatory Commission 2000, p. 21) Tables 9.3 to 9.5 show asset valuation techniques used by two electricity companies, that is Transpower Limited NZ and PowerCo. Table 9.3: Asset values using five different asset valuation techniques (replacement cost, DRC, ORC, DORC and ODV) in ($ million) Capital assets Final decision (30 June (system and nonsystem 2002) assets) RC DRC ORC DORC ODV (Transpower Limited NZ 2002, p. 98) 266

269 Table 9.4: Asset values using five different asset valuation techniques (the replacement cost, DRC, ORC and DORC) in ($ million) Capital assets Final decision (30 June 2006) (system and nonsystem assets) RC DRC ORC DORC ODV 2032 (Transpower Limited NZ 2006, p. 75) Table 9.5: Asset values using five different asset valuation techniques (replacement cost, DRC, ORC and DORC) in ($ million) Capital assets Final decision (2004) (system and nonsystem assets) (*1 000) RC DRC ORC DORC ODV (PowerCo 2004, p. 4) The preference adopted in regulated water businesses and their jurisdictions is to lock in or roll forward the value of RAB, calculated at the start of each regulatory period. It is calculated as the opening RAB of the previous regulatory period, plus the actual capital expenditure over the period, less regulatory depreciation and any disposals. The RAB is adjusted to reflect both the actual capital expenditure and actual funds returned to the 267

270 investors. Future water prices are based on the actual cost in providing water services. Any asset valuation method used is an estimate valid at a particular point in time. Over a regulatory period, regulated water businesses will engage in capital expenditure programs that will be added to the RAB. The existing components of the RAB will be subjected to depreciation. The RAB excludes any asset disposals and any capital contributions (external funding, subsidies) from government or third parties. This method is known as the rolled-forward RAB under the price-cap regulatory regime. It is used to set water prices at the start of a new regulatory period under price-cap regulation. The water price is set to recover revenue and will not change until it is reset at the next periodic price review. Figure 9.1 below shows the plotting of figures collected from Tables 9.1 and 9.2. Four different asset valuation techniques DAC, DIHC, ODV and DORC are compared. Figure 9.1: Comparison of Pricing-based asset valuation techniques Comparison: Pricing-based asset valuation techniques 2500 Capital assets ($M) Independent Competition and Regulatory Commission: AGLGN (Final: Nov 2000) IPART: AGLGN (Final: June 2000) 0 DAC ($) DIHC ($) DORC ($) ODV ($) ,500 2, IPART (2000, p. 8 & 79) and the ICRC (2000, p. 21) The graphical results reveal that when these four asset valuation techniques are plotted against capital assets (system and non-system assets), consistently under the DAC, asset 268

271 value is the lowest, followed by the DIHC; the ODV is the second highest, and the DORC produces the highest asset valuation. Figure 9.2 below plots the figures from Tables 9.3 to 9.5. Five different asset valuation techniques replacement cost, DRC, ORC, DORC and ODV are compared. Figure 9.2: Comparison of Pricing-based asset valuation techniques Comparison: Pricing-based asset valuation techniques 14,000,000 12,000,000 Capital assets ($M) 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 RC ($) DRC ($) ORC ($) DORC ($) ODV ($) PowerCo (2004) (*1000) 1,672, ,058 1,659, , ,538 Transpower Ltd NZ (2006) Transpower Ltd NZ (2002) 0 5,545,000 2,577,000 4,832,000 2,032,000 2,032,000 5,652,000 2,584,000 4,726,000 2,153,000 2,151,000 Transpower Limited NZ (2002, p. 98); PowerCo (2004, p. 4); Transpower Limited NZ (2006, p. 75) The graphical results conclude that when these five asset valuation techniques are plotted against capital assets (system and non-system assets), consistently under DORC asset values are lower than those of the replacement cost, DRC and ORC, but higher than ODV. ODV produces the lowest asset valuation of all the five asset valuation techniques used. 269

272 9.3 Justifications for the findings The choice of different asset valuation techniques involve varying degrees of effort and time to calculate. It can be observed that these different valuation choices result in significantly different valuation figures for the same assets. Consequently, not only will significantly different asset valuation techniques produce different estimates of the RAB, they will also produce different water pricing and investment signals. When the result of seven different asset valuation techniques is put together, it can be concluded that (in descending order), over the life of the assets, the replacement cost asset valuation method will yield the highest asset value, followed by DRC, ORC, DORC and ODV. A depreciated inflation historical cost (DIHC) asset value will be greater than the DAC asset value. Accounting estimates of asset value begin with HCA or the book value. HCA is one of the GAAP, and it is widely accepted by businesses and is often viewed as the best estimate of the value of an asset. In terms of economic efficiency, the DAC and the depreciated inflation adjusted historical cost (DIHC) perform poorly. The RAB under the DAC and depreciated inflation historical cost (DIHC) valuations will be underestimated. That is, water businesses will yield insufficient revenues to finance capital investments, as well poor pricing signals reflected Case studies in water industry RAB and regulator s pricing decision As a natural monopoly, water providers or businesses set water pricing directly based on their assets (RAB). The price of water should only be raised in line with the increased asset value, and if and when it can effectively earn a return on and of capital invested in the business. Long-life assets are built with enough spare capacity to meet current and future water and sewerage services demand, and hence when it is not economical to increase the network capacity each year. 270

273 In each year of the regulatory period, the price of water does not need to be set to recover the annual revenue. Water prices are smoothed over the regulatory period to limit any impact of sharp price increases to customers. If a water business effectively earns a return on and of capital above what is invested, consumers should not be made to pay for the increase in water price; that is, increased earnings by water businesses and at the same time increased earnings for consumers as well as receive no improvement or upgrade in the level of service. This section provides case studies of the water industry in major Australian cities. Each jurisdiction has different planning and reporting cycles (regulatory periods), and it is therefore not possible to present information and analysis as a common year New South Wales The delivery of New South Wales urban water arrangements is summarised in Table 9.6 below. Table 9.6: Bulk water and water service providers in New South Wales Area Name Services Institutional structure Sydney Sydney Water Treatment, distribution Statutory state-owned Corporation and retail corporation Sydney Catchment Authority Bulk water, catchment management Statutory authority Newcastle Hunter Water Bulk water, treatment, Statutory state-owned and Hunter Valley region distribution and retail corporation Other urban centres Local governments (e.g. Wyong City Council, Gosford City Council, Bulk water, treatment, distribution and retail Local government 271

274 Goulburn Wulwaree City Council) State Water Regional and rural bulk Statutory state-owned Corporation water delivery corporation (Marsden Jacob Associates 2006, p. 7) In New South Wales, the Sydney Catchment Authority is one of the two major bulk water storage, which was created in 1999, after a major cryptosporidium and giardia incident affected Sydney s water supply. It is a state-owned statutory authority, responsible for managing and protecting Sydney's catchments and supplying bulk water to its customers, including Sydney Water and a number of local councils. The Sydney Water Corporation is the other major bulk water storage in New South Wales, which is a statutory state-owned corporation; that is, it is wholly owned by the New South Wales Government. The Sydney Water Corporation provides drinking water, recycled water, wastewater services and a few stormwater services to more than four million people in Sydney, Illawarra and the Blue Mountains. Data from 2006 recorded that each day, the Sydney Water Corporation supplies over 1.4 billion litres of water to over 1.6 million homes and businesses each day. It has a network of 255 service reservoirs, 151 pumping stations and km of water mains (Total Environment Centre Inc. 2007, p. 3). Both the Sydney Catchment Authority and Sydney Water Corporation are obliged to charge water at the price determined by the IPART, unless the New South Wales Treasurer s approval is obtained to set a lower price. Hunter Water is a statutory state-owned corporation that provides water and wastewater services to Newcastle, Lake Macquarie, Maitland, Cessnock and Port Stephens, while the Gosford City Council and Wyong Shire City Council are water supply authorities under the Water Management Act The Gosford City Council provides water and sewerage services within the Gosford City Council area, while Wyong Shire Council provides water and sewerage services within its area. 272

275 When undertaking pricing determinations, the IPART seeks submissions from interested parties during each pricing review, and holds public hearings. Table 9.7: Sydney Water total revenue requirement ($ million, ) IPART s draft decision Regulated asset values Operating expenditure Depreciation Total revenue Water rates Sewerage rates Total notional revenue requirement Return on assets IPART s final decision Return on assets Return of assets (depreciation) Operating expenditure Total notional revenue requirement (Independent Pricing Tribunal 2012, pp. 15, 46, 82, 107 & 111) Table 9.8: Sydney s Water proposed notional revenue requirement ($ million, ) including costs of Sydney Desalination Plant (SDP) operating 100 per cent Operating expenditure Allowance for return on assets 273

276 Allowance for regulatory depreciation Total notional requirement (NRR) Estimate of NRR excluding SDP production costs (Independent Pricing and Regulatory Tribunal 2012, p. 45) Table 9.7 compares IPART s final decision on the notional revenue requirement with its draft decision and Sydney Water s proposal. Sydney Water s revenue requirement increased during the determination period, due to forecast increases in the costs of maintaining and renewing its assets, servicing urban growth, implementing the Priority Sewerage Program, and other factors such as the carbon price. Its revenue requirement remained fairly stable, within 1 2 per cent over the determination period, suggesting efficiency and prudence of its past, forecast expenditures and the market cost of capital (Independent Pricing and Regulatory Tribunal 2012, p. 14). On the other hand, Table 9.8 shows the size of the costs and their impact on customers and the SDP s actual operating schedule. Sydney Water set its prices on the basis that its desalination plant would operate at 100 per cent capacity for the entire period, and that customers would be given a refund if there were any savings or variations arising from this operating schedule. The cost of SDP accounts for the difference in the proposed revenue requirement per year, which was between $54 million and $63 million, or approximately $238 million in total over the whole period (Independent Pricing and Regulatory Tribunal 2012, p. 44). If the SDP operates at 100 per cent capacity for any full year, it will cost Sydney Water approximately an additional cost of $50 million ( ) to $65 million ( ). Customers with a 20 millimetre individual meter will have to pay an additional fee of $25 to $31 ( ) in the following year, while customers with a 25 millimetre individual 274

277 meter will have to pay an additional fee of $44 to $61 ( ) in the following year for the next four years Victoria In Melbourne, the 2013 Water Price Review is a five-year regulatory period from 1 July 2013 to 30 June Melbourne s bulk water supplier, Melbourne Water, and its three retail water businesses submitted their Water Plans (including forecast costs, delivery volumes, prices, service levels, and capital works program) to the ESC for review. Prices in the Water Plans, as shown in Table 9.9 below, were based on the building block methodology and were set to meet and recover the total revenue requirement made up of forecast costs for the period. The final decision was released by the ESC following further consideration of the businesses revised pricing proposals, submitted in response to the draft decision and comments in public submissions. Table 9.8: Melbourne Water s proposed revenue requirement compared to draft decision to ($ million ) Proposed by business Draft decision Difference ($) Difference (per cent) ($) ($) Revenue requirement excluding desalination costs Desalination costs Total revenue requirement (Essential Services Commission 2013, p. 5) Table 9.9: Melbourne Water s revenue requirement final decision to ($ million ) 275

278 Final decision Total (estimate) (estimate) (Essential Services Commission 2013, p. 59) Table 9.10: Melbourne Water s breakdown of revenue requirement based on building block methodology final decision to ($ million ) (estimate) (estimate) Operating expenditure Return on capital (existing assets) Return on capital (new investments) Return of capital (depreciation) Tax liability Total (Essential Services Commission 2013, p. 36) Table 9.11: Melbourne water businesses (retailers) revenue requirement final decision (includes gross of Melbourne Water s bulk charges) to ($ million ) Proposed by Final decision business City West Water

279 Proposed by Final decision business South East Water Yarra Valley Water Western Water Retailers total revenue requirement (Essential Services Commission 2013, p. 60) As shown in Table 9.8 above, Melbourne Water sought (proposed) $ million in revenue for a five-year regulatory period. Tables 9.9 and 9.10 show that $4 786 million was approved by the ESC for a shorter period of three years (instead of five years), which commenced on 1 July 2013 for and The need to capitalise a portion of the desalination costs has been confirmed by the ESC. The ESC has accepted Melbourne Water s assessment that the capacity to do so would be in the later years ( ) of the five-year regulatory period. The regulatory period for Melbourne Water was cut down to three years to allow for matters to be re-examined, and for the amount to be capitalised to be decided. In Table 9.11, $ million of combined revenue was sought over the next five years. The businesses charged end-use customers for service, so that they can recover their revenue requirements, including charges paid to Melbourne Water for bulk water and sewerage services. In the final decision, the Commission approved a lower revenue of $ million or $12.1 billion (approximately $3 billion is for desalination costs) for their five-year regulatory period. In the current regulatory period, more than 80 per cent of the increase in total revenue requirement contributed to the increase in the price of water and was due to the commencement of payments for the desalination plant. Operating expenditure Table 9.12: Melbourne Water operating expenditure, to final decision ($ million ) 277

280 Operating expenditure Total proposed Final decision Difference ($ m) Difference (per cent) Desalination payments (61%) Controllable costs Regulatory charges Total (Essential Services Commission 2013, p. 80) Table 9.10 shows Melbourne s Water total expenditure is $ million for the fiveyear regulatory period. However, the desalination cost is a major cost that fundamentally changed Melbourne Water s cost profile. The desalination plant represents 61 per cent of Melbourne Water s total annual operating expenditure for the regulatory period (Table 9.12). Return on capital Capital expenditure The ESC approved $ million of capital expenditure for the next three years. Included in this amount are the changes to the timing of delivery of certain projects, such as the Western Treatment Plant Capacity Augmentation Stage 2 Upgrade, and the scrapping of projects such as City West Water s Altona Stage 2. Regulatory asset base Table 9.13: Updated RAB ($ million )

281 Opening RAB Plus gross capital expenditure Less government contributions Less customer contributions Less proceeds from disposals Less regulatory depreciation Closing RAB (Essential Services Commission 2013, p. 36) Table 9.13 shows the updated RAB. As at 1 July 2012, the ESC approved the initial RAB ($ million) to reflect the verified net capital expenditure. Subsequent years opening RAB are based on forecasts by the Commission. Any difference between assumed and actual net capital expenditure for will be adjusted when the opening RAB is calculated for the next fourth regulatory period. In Table 9.14 below, the closing RAB for was $ million, which became the opening RAB (capital expenditure) for The lesser of either, the actual net capital expenditure or the 2008 determination forecast of net capital expenditure, was proposed by the Commission for This approach mainly reflects the capital expenditure; it allows the business an incentive to deliver projects on schedule. For the final year of the previous regulatory period, the Commission adopted updated forecasts of the previous regulatory period to recognise a sharp increase in water security projects at the time. A number of specific projects initiated in response to government policy were rolled into Melbourne Water s RAB and considered capital expenditure. These were the Eastern Treatment Plant Tertiary Upgrade (cost $36.4 million), the Eastern Drop Structure Air Treatment and Civil Works (cost $6.9 million), the Silvan Fluoride Plant Upgrade (cost $5.8 million) and the IT System Renewals Asset Management System (cost $4 million). Table 9.14: Melbourne Water rolled-forward RAB ($ million ) 279

282 (estimate) (estimate) Opening RAB Plus gross capital expenditure Less government contributions Less customer contributions Less proceeds from disposals Less regulatory depreciation Closing RAB (Essential Services Commission 2013, pp. 36 & 101) Table 9.13 and table 9.14 above shows that the opening asset base for each year is calculated by the use of annual forecasts for net capital expenditure, regulatory depreciation and disposals for subsequent years in the regulatory period Queensland An overview of the water operation and ownership in Brisbane and the Gold Coast is provided in Table 9.15 below. Table 9.15: Overview of operation and ownership in Brisbane and the Gold Coast Brisbane Gold Coast Infrastructure Operators Owners Operators Owners Storage (dams) SEQ Water Queensland SEQ Water and Queensland Government GCW Government and local and local 280

283 Brisbane Gold Coast Infrastructure Operators Owners Operators Owners governments (incl. Brisbane and Gold Coast City Councils) governments (incl. Brisbane and Gold Coast City Councils) Treatment/ transport BW Brisbane City Council GCW Gold Coast City Council Reticulation BW Brisbane City Council GCW Gold Coast City Council (Marsden Jacob Associates 2006, p. 60) Table 9.16: Allconnex (Gold Coast City Council, Logan City Council and Redland City Council) RAB roll-forward Opening RAB ($m) plus net capital expenditure (includes capital expenditure as commissioned, less disposals, donated assets and cash contributed) plus indexation less depreciation less disposals Equals RAB (Queensland Competitive Authority 2012, p. 58) Table 9.17: Capital program, by product and expenditure driver ($000s) Product

284 (actual) Drinking water Other core water Wastewater Trade waste Total capital expenditure (Queensland Competitive Authority 2012, p. 7) In Table 9.16, Allconnex Water s interim opening RAB was $ million as at 1 July As per Table 9.17, in , Allconnex Water s capital expenditure was expected to increase to $289.5 million compared with $217.5 million in , but it is expected to be relatively stable from to Approximately 70 per cent of the forecast expenditure for the year is accounted by wastewater, especially in relation to major wastewater expenditures associated with growth in Coombabah, Loganholme and Stapylton wastewater catchments. These forecast that the capital expenditure programs will start at a lower but more achievable level of capital expenditure, and will progressively increase to achieve optimum resource efficiency and increased capacity and capability (Queensland Competitive Authority 2012, pp. 6 7). The two largest capital expenditure projects for Allconnex Water are the Stapylton Wastewater Treatment Plant and the Merrimac West Wastewater Upgrade. Construction of the Stapylton Wastewater Treatment Plant was deferred in favour of an upgrade to the adjacent Beenleigh Wastewater Plant, and reconfiguration of the Beenleigh and Loganholme Wastewater catchments. The reconfiguration allowed transfer of loads from the Beenleigh and Loganholme Wastewater Treatment Plant, and use of free capacity within Loganholme Wastewater Treatment Plant, with an improved capacity of 66 ML/d compared with the loading of 45 ML/d. This strategy reduced anticipated capital costs by approximately $60 million over the next five years, and provided much lower ongoing operational costs compared with establishment of the new Stapylton Wastewater Plant. Similarly, the Merrimac West Wastewater Upgrade was reviewed following the development of a Target Outturn Cost. The cost was approximately $126 million more than the alternative pump station, which 282

285 meant that implementation of the project based on the tunnel option was suspended in favour of development of an alternative arrangement which is currently underway (Queensland Competitive Authority 2012, p. 60). Allconnex Water calculates its maximum revenue requirement using the building block methodology, represented by the sum of capital expenditure, deprecation, operating expenditure and taxation, and less indexation. In , Allconnex Water s total MAR for all regulated services was $807 million, an increase of $104 million (14.9 per cent) from because of higher bulk water costs and capital investment across its operating area. Due to forecast revenue increases, Allconnex Water was operating below lower-bound pricing, and its MAR for three years from to is forecasted to increase by 15.5 per cent, to a total of $932 million, in The main reasons for this increase are the continued upward trend in the bulk water price path that contributes to higher annual operating expenditure, the business s continued significant investment in prudent and efficient capital projects to provide for new growth, and improvements/refurbishments of existing assets to maintain high service quality (Queensland Competitive Authority 2012, pp. 8 9 & 85). Recovery of total MAR is forecast to be 77.9 per cent in , and will increase marginally to 78.3 per cent in The history of under-recovery of MAR is mostly due to external cost pressures, such as increasing bulk water charges and Queensland Government legislation to cap distributor-retail price increases at CPI for both and Due to this two-year price cap, Allconnex Water was under a revenue glide path to minimise price increases to customers. Over the longer term, the shortfall in cost recovery will be recouped in later years with single revenue that exceeds MAR. In doing so, it ensures that price increases are smoothed and price shocks to customers are minimised (Queensland Competitive Authority 2012, pp. 8 9 & 86-87) South Australia Table 9.18: South Australia water estimates total revenue requirement SA Water ( prices $ million) 283

286 Regulated asset values Legacy assets New assets Asset values Upper revenue pricing Operating expenditure Depreciation Return on assets (6 per cent) Total revenue Water rates Water sales Sewerage rates Community service obligations Other Total revenue (South Australian Government 2010, p. 61) Table 9.19: Rolled-forward RAB for South Australia water and wastewater assets Nominal $ million Opening balance Capital expenditure Inflation adjusted Depreciation (135) (154) (165) (209) (222) (234) Closing balance

287 Water assets (nominal $ million) Nominal $ million Opening balance Capital expenditure Inflation adjusted Depreciation (93) (103) (110) (148) (156) (163) Closing balance Wastewater assets (nominal $ million) Nominal $ million Opening balance Capital expenditure Inflation adjusted Depreciation (47) (49) (51) (55) (61) (71) Closing balance (South Australian Government 2009, p. 44) Table 9.20: South Australia water forecast capital expenditure ($ million nominal) Nominal $ million Total

288 Nominal $ million Total Transparency Statement Water Wastewater Total Transparency Statement Water (actual) Wastewater (actual) Total (actual) Difference (324) 56 (Essential Services Commission of South Australia 2010, pp. 13 & 34) Table 9.18 provides the estimates of South Australia Water s total revenue requirement from 2008 to 2014, while Table 9.18 sets out the proposed (estimate) rolled-forward RAB for South Australia Water, including capital expenditure from 2007 to The ESCOSA (2010, pp. 13 & 34 35) noted that a key driver for the 60 per cent real increase in water prices between 2008 and 2009 ($84 per year or $1.62 per week) was because of the significant increase in capital expenditure in relation to the government s water security investments. This particularly referred to the ADP, the implementation of the Network Water Security Program designed to better connect the northern and southern water supply systems, and the purchase of Murray River water to ensure that sufficient quantity of water was available for critical human needs. Water prices increased by an average of 17.9 per cent in real terms in , followed by an average increase of 21.7 per cent in and the capital costs forecasts 286

289 provided for , and future years have changed since the forecasts due to the following reasons: The ADP at Pt. Stanvac was known to be the highest water capital expenditure in Australia during , costing approximately $1.82 billion. It not only represents over half of the total forecast capital expenditure, but also dominated most of the capital expenditure program from to It has delivered approximately 15 million litres per day since April 2011, progressing to 50 GL capacities by end of August 2011, and to 100 GL full capacities at the end of December The decision by the South Australian Government to expand ADP is reflected in the significant increase in capital expenditure in and , as shown in Tables 9.18 and 9.19, as compared with the estimates provided in in Table For this reason, the increase in capital expenditure has impacted on nearly 60 per cent real increase in water prices since Metropolitan sewerage capital expenditure increased significantly above levels in and , to meet the demand growth. The two key upgrade projects were the capacity upgrades of Christies Beach and Aldinga Wastewater Treatment Plants. Upgrades to treatment plants driven by growth in regional water capital expenditure declined from to , before increasing again in due to upgrades to treatment plants driven by growth. Upgrades to treatment plants driven by growth in regional sewerage capital expenditure declined from to , before increasing again in Table 9.21: South Australia water key capital expenditure projects ($ million nominal) Project Expected completion expenditure Estimated total cost ADP December ,824.0 Christies Beach Wastewater Early

290 Project Expected completion expenditure Estimated total cost Treatment Plant Upgrade Glenelg to Adelaide December Parklands Park Lands Recycled Water Southern Urban Reuse December Bird in Hand Wastewater Treatment Plant Nutrient Reduction December (Essential Services Commission of South Australia 2010, p. 35) Table 9.21 lays out a summary of the top five capital expenditure projects by estimated total cost in South Australia. Water prices are expected to almost double over the next four years, so that the government can fully recover the costs associated with major water security projects and other costs such as externalities (Coastal Water Study, Environmental Impact Assessment Essential Services Commission of South Australia 2010, p. 18) Western Australia The institutional and governance arrangements of the urban water supply arrangements in Western Australia are summarised in Table 9.22 below. Table 9.22: Water service providers in Western Australia Area Name Services Institutional structure Western Australia (other than Bunbury and Busselton) Western Australia Water Corporation Bulk water, catchment management, treatment, distribution and retail Statutory stateowned corporation 288

291 Area Name Services Institutional structure Bunbury AQWEST Bulk water, treatment, Statutory authority distribution and retail Busselton BWB Bulk water, treatment, distribution and retail Statutory authority (Marsden Jacob Associates 2006, p. 85) Table 9.23: Water Corporation revenue requirement, to Value ($ million, real dollars as of June 2005) Asset account Opening asset value Capital expenditure Depreciation Closing asset value Cost of service Operating expenditure Depreciation Return on assets Gross cost of service Net revenue requirement Asset account Opening asset value Capital expenditure Depreciation Closing asset value Cost of service

292 Asset account Operating expenditure Depreciation Return on assets Gross cost of service Net revenue requirement (Economic Regulation Authority 2005, p. 92) Table 9.24: AQWEST revenue requirement, to Value ($ million, real dollars as of June 2005) Asset account Opening asset value Capital expenditure Depreciation Closing asset value Cost of service Operating expenditure Depreciation Return on assets Gross cost of service Net revenue requirement Asset account Opening asset value Capital expenditure Depreciation Closing asset value Cost of service

293 Operating expenditure Depreciation Return on assets Gross cost of service Net revenue requirement (Economic Regulation Authority 2005, p. 135) Table 9.25: Busselton revenue requirement, ($ million, real dollars as of June 2009) Asset account Opening asset value Capital expenditure Depreciation Closing asset value Cost of service Operating expenditure Return on assets Depreciation Gross cost of service Net revenue requirement Asset account Opening asset value Capital expenditure Depreciation Closing asset value Cost of service Operating expenditure

294 Return on assets Depreciation Gross cost of service Net revenue requirement (Economic Regulation Authority 2005, p. 168) As summarised in Table 9.23, Western Australia Water Corporation s revenue requirement over the period from to at a present value with a discount rate of 5.63 per cent (real pre-tax) is $6 240 million. The Water Corporation s proposed asset value of $ million as at 30 June 2005 was determined and verified by its regulator, the ERA, by constructing a set of regulatory accounts based on the Water Corporation s forecast of operating and capital costs. The asset value is the value determined through the building block methodology, where prices are set based on operating and maintenance costs, depreciation, and a return on the regulatory asset value. The Water Corporation s capital expenditure program is projected to a total of $6 196 million or an average of $620 million per year over the 10-year period from to (Economic Regulation Authority 2005, p. 74). The basis for water tariffs set by the government followed the 2005 inquiry, and formed the Water Corporation s capital expenditure program for the regulatory period (three years) from to The proposed capital expenditure amount was $1 720 million (in nominal dollars), but the actual expenditure for that period was $2 011 million; an increase of $291 million, mainly due to cost escalation (+$149 million), additional projects (+$168 million, including $69 million on various wastewater treatment plant projects, $30 million on infill sewerage, $20 million on the Southern Seawater Desalination Plant, and $14 million on the Gnagara Mound Replenishment Trial), deletion of the South West Yarragadee project (-$103 million), and expenditure carried over from projects that were not completed in earlier years ($99 million) (Economic Regulation Authority 2009, pp ). In , the government approved the Water Corporation s capital expenditure for the period to of $4 027 million (in nominal dollars). This projected capital expenditure was expected to average $805 million per year, in comparison with 292

295 $670 million per year over the previous regulatory period to (Economic Regulation Authority 2009, pp ). Major projects for this regulatory period from to included $935 million on the Southern Seawater Desalination Plant, $2 674 million on regional projects in Western Australia, $230 million on the Alkimos Wastewater Treatment Plant, $205 million on the Mundaring Water Treatment Plant, $145 million on the Beenyup Wastewater Treatment Plant, and $37 million on the Woodman Point Odour Control (Economic Regulation Authority 2009, pp ). Table 9.24 demonstrates the basis for water tariffs set by the government following the 2005 inquiry, and formed the Water Corporation s capital expenditure program for the regulatory period (three years) from to for AQWEST. The proposed capital expenditure amount was $11.9 million (in nominal dollars), but the actual expenditure for that period was $19.7 million an increase of $7.8 million. The increases in capital expenditure were mainly based on two reasons: first, capital construction was for an 8.4 km pipeline at a cost of $4.6 million (the City Link Project), with the purpose of reducing the need to produce water from AQWEST s coastal bores; second, capital expenditure was to make provision for future high-volume demand from development in Bunbury. For the following regulatory period from to , AQWEST s proposed capital expenditure program came to $34.4 million (in nominal dollars), with an average of $3.7 million per year, compared with $6.5 million per year over the previous regulatory period from to The capital expenditure was $6.3 million on water treatment plants, and $5.0 million on mains (Economic Regulation Authority 2009, p. 127). Table 9.25 demonstrated the basis for water tariffs set by the government, following the 2005 inquiry, and forms the Water Corporation s capital expenditure program for the regulatory period (three years) from to for Busselton Water. The proposed capital expenditure amount was $6.4 million (in nominal dollars), but the actual expenditure for that period was $5.8 million. For the following regulatory period from to , Busselton Water s proposed capital expenditure program amounted to $19.5 million (in nominal dollars), with an average of $3.9 million per year, compared 293

296 with $1.9 million per year over the previous regulatory period. The main capital expenditure was the $2 million purchase of a new administration building (Economic Regulation Authority 2009, p. 128) Tasmania Table 9.26 shows the upper revenue limit ($ 000) used in calculation of RAB for existing and new assets for the three main water businesses in Tasmania: Ben Lomond Water (operates in the northern region), Cradle Mountain Water (operates in the north western region) and Southern Water (operates in the southern region). These new assets are rolled forward as the existing assets, and their value will increase over time as water businesses invest in new assets. The regulated entities propose that capital expenditure for each year of the regulatory period should be split between water and sewerage assets. Table 9.26: Upper revenue limit ($ 000) Ben Lomond Water Water Capital expenditure (existing) Capital expenditure (new) Depreciation (existing) Depreciation (new) Operating expenditure Total water Wastewater Capital expenditure (existing) Capital expenditure (new) Depreciation (existing) Depreciation (new) Operating expenditure Total wastewater , Total Cradle Mountain Water 294

297 Water Capital expenditure (existing) Capital expenditure (new) Depreciation (existing) Depreciation (new) Operating expenditure Total water Wastewater Capital expenditure (existing) Capital expenditure (new) Depreciation (existing) Depreciation (new) Operating expenditure Total wastewater Total water Southern Water Capital expenditure (existing) Capital expenditure (new) Depreciation (existing) Depreciation (new) Operating expenditure Total water Wastewater Capital expenditure (existing) Capital expenditure (new) Depreciation (existing) Depreciation (new) Operating expenditure Total wastewater Total (Office of Tasmanian Economic Regulator 2012, pp ) 295

298 In Tasmania, the current regulatory period covers a period of three financial years, starting from 1 July 2012 to 30 June A state government review in 2006 revealed that the prices charged for water did not cover the cost of providing water services (and sewerage) for all Tasmanians. It was found that water prices were too low to fund both new plant and equipment, and to replace worn-out assets it needed to meet acceptable standards of safe drinking water, and public and employee safety, and to control pollution to Tasmania s environment. Water services in Tasmania were not only below the standard, but it was likely to fall further as Tasmania s water and sewerage sector was not financially sustainable. The Tasmanian Government made a series of reforms to the water (and sewerage) industry to ensure that sufficient funds will be available to meet the cost of providing water services, maintain the existing water infrastructure, and invest in the new and upgraded infrastructure to ensure that Tasmania s water is safe to drink and that sewerage does not continue to pollute its environment (Office of the Tasmanian Economic Regulator 2012, p. 1). For Ben Lomond Water, in real terms, revenue was projected to grow by 9 per cent over the first regulatory period, and even though revenue is now trending towards the lowerbound pricing, it is still below a sustainable level. The Office of the Tasmanian Economic Regulator (2012, p. 70) predicted that the MAR will not reach the expected levels by 30 June 2015, as the revenue of $ million is just over two-thirds of the upper-bound pricing limit of $ million. Over the first regulatory period, Ben Lomond Water will experience increased revenue from customers, which will be utilised to pay off debt and returns to owners, and to fund capital expenditure at levels which are expected to decline after the first year of the initial regulatory period. For Cradle Mountain Water, in real terms, revenue is projected to grow by 13 per cent over the first regulatory period, and revenue is trending towards the lower-bound pricing, and is transitioning from an unsustainable level over the previous period. In , revenue is expected to be above the lower-bound pricing. The Office of the Tasmanian Economic Regulator (2012, p. 72) predicted that the MAR will not be reached by 30 June 2015, as the revenue of $ million is well short of the upper-bound pricing limit of $ million. Over the first regulatory period, Cradle Mountain Water will experience 296

299 increased revenue from customers, which will be utilised to pay off debt, to meet the increase in operating expenditure and returns to owners, and to fund capital expenditure at levels that are expected to decline over the period. For Southern Water, in real terms, revenue is projected to grow by the slowest rate of 3 per cent over the first regulatory period. Revenue remains under the sustainable level under the lower-bound pricing. With debt costs projected to increase by 34 per cent, the Office of the Tasmanian Economic Regulator (2012, p. 73) predicted that the MAR will not be reached by 30 June 2015; revenue of $ million is less than two-thirds of the upper-bound pricing limit of $ million. As a result of price reforms over the first regulatory period, Southern Water will experience a small annual increase in revenue from customers. However, due to lack of revenue growth, Southern Water remains in a financially unsustainable position and is only close to achieving the lower-bound pricing Key findings The core in any regulation of utilities is the RAB, an accounting figure that contains the physical bundle of new and existing assets. This value is the opportunity cost of investment, and represents the investors claims in the business, where return on capital is required and depreciation represents the return of capital. The economic problem in relation to utility businesses being a natural monopoly is that they are part of a capital-intensive (in the tens to hundreds of billions of dollars) industry, which means that their assets are long-life (10 to over 100 years) and immobile, and they are sunk costs once invested with no alternative use. The calculation of the building block equation and the RAB means asset valuation requires not only a significant amount of planning (each regulatory period lasts from three to five years), but also structuring from a regulatory perspective. The right operating and regulatory environment needs to be created, and it demands a high degree of understanding between all parties involved (the business, investors and regulator). The RAB (asset valuation) may not be suitable for all markets due to its complexities. It is best suited to utility businesses that are natural monopolies, subjected to regulation and facing limited market risk. It works exceptionally well where large capital investments are required. 297

300 The RAB used in the building block equation brings in significant amounts of capital into infrastructure on a long-term basis. It attracts large amounts of capital into infrastructure (utilities), and at the same time provides transparent and consistent mechanisms that reduce investor risk by providing stable, deep capital resources in the long term, and better defined cash flow. On one hand, investors can recover the exact capital they invest into the assets, as RAB is based on financial (operating) maintenance as discussed in Chapter Three. That is, a price cap is placed on consumer prices. On the other hand, the RAB is based on a regulatory contract and there is no guarantee of the exact capital invested into the assets. Return on RAB is the price of water that customers pay for the past investments, but is reflected in the current and future price of water. Past expenditures are not only sunk, but also largely irrelevant for efficient decisions in relation to future usage and investment. The building block equation, specifically the return on capital, suggests that there will not be any profit forecasted from the calculation of MAR. It is therefore inappropriate for the business to earn profits such as those realised or anticipated in perfectly competitive (non-regulated) markets. RAB calculations are inconsistent across jurisdictions due to the size of businesses and the regulatory period in which they are done and compared. Utility businesses are not restricted to past investments only, as they also engage in carrying out new investments and running day-to-day business, as reflected in OPEX. The inherent flaw in the calculation of MAR is the failure to consider any increment in cost of capital during the regulatory period, if there is any. The price of water is not set to recover the annual revenue requirement in each year of the regulatory period, as it is smoothed over the regulatory period to limit any impact of sharp price increases on consumers. The value of water service or the true costs of providing service is not reflected in water rates (price). 298

301 9.5 Regression analysis The Least Squares Regression Method is used to predict whether there is a link between investment; that is, net capital expenditure and asset valuation techniques used in water utility businesses in Australia. The least squares regression method has been chosen for this thesis because it can estimate the true value of any quantities based on a consideration of errors in observations or measurements. The analysis found mixed relationships between the residuals, which cancel each other out and explains how well the line fits by adding up all the residuals. The sum of all the squared residuals shows how well the line fits the data set. A standard deviation is calculated to measure the spread between the residuals. Data are collected from the WSAA website and water businesses industry reports over eight years from 2004 to The primary purpose of the analysis is to model the linear relationship, particularly between asset valuation techniques (independent variable) and net capital expenditure (dependent variable). Values of the independent variables (i.e. asset valuation techniques, length of pipes connecting residential properties water supply and the number of population connected to urban water services) are collected to predict the behaviour and value of the dependent variable, net capital expenditure. 299

302 Table 9.27: Least Squares Regression Method (DORC = 1 and Line in the sand, EV = 0) Dependent Variable: CAPX_TA (net capital expenditure) Method: Least Squares Sample (adjusted): 137 Included observations: 28 after adjustments Variable Coefficient Std. Error t-statistic Prob. C ASSET_VALUATION LENGTH_OF_PIPES 4.60E E POPULATION -1.60E E R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid Schwarz criterion Log likelihood Hannan-Quinn criter F-statistic Durbin-Watson stat Prob(F-statistic) CAPX_TA = net capital expenditure ASSET_VALUATION = asset valuation technique Depreciated optimised replacement cost (DORC) = 1; Line in the sand, EV = 0; LENGTH_OF_PIPES = length of pipes connecting residential properties water supply POPULATION = the number of population connected to urban water services Based on Table 9.27, the straight line can be written as: CAPX_TA = ASSET_VALUATION LENGTH_OF_PIPES POPULATION In this regression analysis, dummy variables for asset valuation techniques are used. Net capital expenditure (dependent variable) is influenced by both the quantitative variables (length of pipes connecting residential properties water supply and the number of population connected to urban water services) and the qualitative variable (asset valuation techniques). In the first regression analysis, dummy variables (independent variable) or dummy explanatory variables take the values of 1 for DORC and 2 for line in the sand, EV (table 9.27). The dummy variables eliminated some categorical effect that may shift 300

303 the outcome of the regression and sorted data into mutually exclusive categories, that is DORC = 1 and EV = 0 (table 9.27). The R-squared number for both regressions (Table 9.27 and Table 9.28) is known as the coefficient of determination when expressed as a percentage. For this thesis, the value of the R-squared number is 0.769; meaning 76.9 per cent of the total sum of squares can be explained by the estimated regression equation above when used to predict or forecast future net capital expenditure. This suggested that 76.9 per cent of the total variation in net capital expenditure (dependent variable) can be explained by its relationship with asset valuation techniques, length of pipes connecting residential properties water supply, and the number of population connected to urban water services (independent variables). From Table 9.27, the slope 0.36 means that on average, every $1 increase in DORC asset valuation technique resulted in a 36 cent increase in net capital expenditure. Likewise, on average, every 1 km increase in length of pipes will result in cent increase in net capital expenditure. The number of population connected to urban water services has a negative impact on net capital expenditure. On average, every one increase in the number of population connected to urban water supply will result in a negative cent in net capital expenditure. The t-statistic of the Least Squares Regression Method is the regression coefficient of a given independent variable, divided by its standard error. The coefficient of asset valuation technique was significant with a positive sign t-statistics of 3.8 (Table 9.27), implying that DORC asset valuation technique positively impacted on net capital expenditure. It can be therefore concluded that DORC asset valuation technique (independent variable) has a significant positive impact on net capital expenditure (dependent variable). In theory, DORC asset valuation technique is the upper-bound pricing. Higher asset valuation resulted in higher price of water and higher level of capital expenditure by the business. 301

304 Table 9.28: Least Squares Regression Method (DORC = 0 and Line in the sand, EV = 1) Dependent Variable: CAPX_TA (net capital expenditure) Method: Least Squares Sample (adjusted): 137 Included observations: 28 after adjustments Variable Coefficient Std. Error t-statistic Prob. C ASSET_VALUATION LENGTH_OF_PIPES 4.60E E POPULATION -1.60E E R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid Schwarz criterion Log likelihood Hannan-Quinn criter F-statistic Durbin-Watson stat Prob(F-statistic) CAPX_TA = net capital expenditure ASSET_VALUATION = asset valuation method Depreciated optimised replacement cost (DORC) = 0; Line in the sand economic value (EV) = 1; LENGTH_OF_PIPES = length of pipes connecting residential properties water supply POPULATION = the number of population connected to urban water services In the second regression analysis as in Table 9.28, the dummy variable for asset valuation techniques is DORC = 0 and line in the sand, EV = 1. The slope of negative 0.36 means that on average, every $1 increase in line in the sand, EV asset valuation technique resulted in a 36 cent decrease in net capital expenditure. The length of pipes and the number of population connected to urban water supply remained the same. The coefficient of asset valuation is significant, with a negative sign (t-statistics of -3.8) implying that line in the sand, EV asset valuation technique impacted negatively on net capital expenditure. 302

305 It can therefore be concluded that the line in the sand, EV asset valuation technique (independent variable) has a significant negative impact on net capital expenditure (dependent variable). In theory, EV asset valuation technique is the lower-bound pricing. That is, lower asset valuation technique resulted in lower price of water and lower level of capital expenditure by the business. High investment is associated with DORC asset valuation technique rather than with the EV asset valuation technique. A water business invests in capital expenditure regardless of the asset valuation techniques used. The findings of both regression analysis, particularly whereby the length of pipes and the number of population connected to urban water supply remained the same regardless of the asset valuation techniques used is consistent with the argument made by Topp and Kulys (2012, p. 98). That is, it takes many more years for the aggregate supply capacity and existing supply capacity, including new capacity, to be fully utilised after investment is made and new water supply assets are operational. Dam levels cannot be raised every year, and pipes and wastewater treatment plants cannot be widened each year to meet the growing demand for water and wastewater treatment. Water assets are constructed with a long-term aim of meeting both current and future demand. Output will increase in line with population growth and the available capital capacity. The trend is that once these lumpy new assets are constructed, capital expenditures will slow down. This regression analysis confirmed the hypothesis of this thesis, that is, there is a direct relationship between investment in water assets which impact on the RAB and ultimately the price of water. 9.5 Summary of current institutional structure arrangements The majority of Australian households (i.e. 93 per cent) are connected to reticulated network of water and wastewater services. These water services are predominantly provided by vertically integrated and government-owned water providers that are regulated monopoly businesses. There is some vertical disaggregation in Australian major metropolitan areas. For example, vertical disaggregation can be observed between bulk supply and retail services, while horizontal disaggregation can be observed between 303

306 geographical regions. Water businesses do not compete with each other in the provision of water services. In general, urban water and its related systems are not physically connected. The key difference is a large variety of institutional arrangements and structures that have emerged across different Australian jurisdictions and their regions. Table 9.29 below summarises the institutional structure arrangements in major Australian cities. Table 9.29: Institutional structure of water and wastewater provision in major Australian cities Region Metro Regional New South Wales Sydney is vertically separated Local government authorities between Sydney Water predominantly provide these Corporation and Sydney services outside of Sydney and Catchment Authority Newcastle Victoria Melbourne Water is vertically Reform in 1994 has resulted in separated; the three water 140 non-metropolitan water retailers are horizontally providers, consolidated into 13 disaggregated and later 15 state-owned regional urban water authorities providing integrated water services Queensland There are separate vertically Local government authorities disaggregated authorities for predominantly provide these manufactured water, bulk services, with the exception of water, and bulk transport and South East Queensland grid management; there are 10 local government authority-owned retailers which provide retail services South Australia South Australia Water Water services are provided by provides water and South Australia Water; local wastewater services; it is a government authorities provide 304

307 Region Metro Regional vertically integrated water sewerage services in nonmetropolitan utility areas Western Australia Western Australia Water Water services are provided by Corporation provides water Western Australia Water services to Perth; it is a Corporation or other water vertically integrated water boards; local government utility authorities provide sewerage services in non-metropolitan areas Tasmania Southern Water provides Local governments previously Hobart water services; it is a provided these services; however, vertically integrated water in 2009 three regional utilities utility supported by a common shared services utility amalgamated Australian Capital Territory ACTEW AGL is the provider of water services. It is a - vertically integrated water utility. (National Water Initiative 2011, p. 7) 9.6 Water Pricing Principles as outlined by the NWI The NWI is the national blueprint for water reform, and it was agreed upon by the Commonwealth and state and territory jurisdictions at the COAG meeting in June These NWI Pricing Principles drew from not only those in the 1994 COAG Water Reform Framework, but also the 1999 Tripartite Agreement, the NWI, as well as the report of the Expert Group on Asset Valuation Techniques and Cost Recovery Definitions for the Australian Water Industry (the Expert Group) (NWI 2010, p. 3). The NWI Pricing Principles are based on the COAG Water Resource Pricing Principles. It was developed by the Expert Group who made a number of recommendations regarding asset valuation and cost recovery. The group suggested that the price of water be set by the jurisdictional regulators, who in examining full-cost recovery as an input to 305

308 price determinations, should have regard to these pricing principles. The deprival value methodology should be used for asset valuation. These pricing principles are the basis for setting water pricing in all jurisdictions, and have been agreed by all state and territorial governments. If a decision was made not to apply these principles in a particular case, Australian governments agree that the reasons need to be tabled in the parliament. Tasmania joined in later in June 2005, followed by Western Australia in June 2006 (NWI 2010, p. 3). The NWIC established the Steering Group on Water Charges, not only to provide technical advice on water pricing, but also to support the implementation of NWI pricing reforms. Later, on 23 June 2010, the NWI Pricing Principles were also endorsed by the Natural Resource Management Ministerial Council. The pricing principles set by the NWI represent a shared commitment by governments to increase the efficiency of Australia s water use, which leads to greater certainty for investment and productivity, both for the rural and the urban communities, and for the environment (NWI 2010, p.2). The Australian governments have made commitments to best-practice water pricing under the NWI, including promoting economically efficient and sustainable use of water resources, water infrastructure assets and government resources devoted to the management of water; ensuring sufficient revenue streams to allow efficient delivery of the required services; facilitating efficient functioning of water markets, giving effect to the principle of user-pays and achieving pricing transparency in respect of water storage and delivery in irrigation systems and cost recovery for water planning and management; and avoiding perverse or unintended pricing outcomes. Paragraphs 65 (iii) and 67 of the NWI state the main objective of the pricing principles is to assist jurisdictions (the Commonwealth and state and territory governments) to achieve consistency in water pricing. The set principles for recycled water and stormwater reuse have been developed consistent with NWI paragraph 66(ii), to assist states and territories to meet their commitment in developing pricing policies for recycled water and stormwater use, congruent with pricing policies for portable water. 306

309 The four sets of pricing principles are principles for recovering capital expenditure, principles for setting urban water tariffs, principles for recovering the cost of water planning and management, and principles for recycled water and stormwater reuse. The principle for recovery of capital expenditure suggests that capital expenditure (including expenditure for replacement of existing assets, to expand the stock of assets, to meet increases in demand, and to meet required service standards and any increases in regulatory obligations) in water businesses constitutes the major proportion of costs recovered through water charges. Figure 9.3 (below) summarises the COAG Water Resource Pricing Principles. The upperbound pricing provides guidelines to avoid monopoly rents. In practice, a water business should not recover more than the operational, maintenance and administrative costs, externalities, taxes or tax equivalent regimes, provision for the cost of asset consumption, and cost of capital. This is the value consistent with the price that would be charged if a hypothetical (efficient) new entrant enters the market. DORC valuation would be able to achieve this when implemented correctly. Rationalisation for the upper-bound pricing is that in a perfectly contestable market, prices would reflect the cost structure of the efficient new entrant, and prices set higher than those earned in a contestable market would contain monopoly rent. The lower-bound pricing provides guidelines for a water business to remain viable. In practice, a water business should recover, at least, the operational, maintenance and administrative costs, externalities, taxes or tax equivalent regime, interest cost of debt, and dividends (if any), and make provision for future assets refurbishment/replacement. Dividends should be set at a level that reflects commercial realities and stimulates a competitive market outcome (NWI 2010, p.10). Figure 9.3: COAG Water Resource Pricing Principles 307

310 Upper-bound pricing: provides guidelines to avoid monopoly rents Lower-bound pricing: provides guidelines for water businesses to remain viable A review of the financial performance of 24 water utility government trading enterprises for the period between and was released by the Australian Government Productivity Commission in July The water businesses examined in the report varied substantially in size, with the smallest provider controlling $105 million in assets, and the largest controlling $12.3 billion. The review found that the 24 water utility government trading enterprises recovered their costs; in fact, they reported positive returns on capital assets in , which was consistent with achieving lower-bound pricing. Ten of the 24 water utility businesses were providers of urban water services, and half of these (5) were providers of urban water services. They reported returns on assets exceeding the risk-free rate of return ; that is, 5.8 per cent of the return on 10-year Commonwealth Government bonds. This was the definition of upper-bound pricing adopted by the Productivity Commission. These five water businesses are considered to be operating commercially. Principle 6 of the COAG Pricing Principles notes that economic regulators should determine the level of revenue for a water business based on efficient resource pricing, which includes the need to use pricing to send the correct signals to consumers on the high cost of augmenting their water supply (NWI 2010, p. 18). That is, water is priced through a two-part tariff arrangement, where there are separate components for access to the infrastructure (this is the fixed service availability charge) and for usage (this is the variable, volumetric or usage charge). The variable component of water charges is the inclining block tariff. In most jurisdictions, two or more blocks or tiers (up to 11) are incorporated into variable charges 308

311 levied on residential users. The variable component of the charge increases when water consumption exceeds pre-determined blocks or thresholds. The inclining block tariffs are set with reference to an estimate of the long-run marginal cost of supply, so that the correct pricing signals are sent (NWI 2010, p. 18). The Steering Group on Water Charges identified that there were different areas in pricing approaches across jurisdictions. The most obvious three were the approaches to recover capital expenditure, the approaches to setting urban water tariffs, and the approaches to recovering the costs of water planning and management (NWI 2010, p. 2). Principles for urban water tariffs are developed where there are large monopoly water providers. That is, there is an absence of water trading competitive pressures to bring about efficient levels of cost recovery and associated tariff structures. There are many reasons why operation of water trading in an urban context is limited, and due to physical limitations it is likely to remain so. Water service availability and usage charges determine the cost of water to users, and the term service availability charge describes the access/connection/fixed charge, and the term water usage charge describes the variable charge. Paragraphs 6 8 of the NWI Pricing Principles note the approaches to setting urban water tariffs, in a way which comprises a service availability charge and a water usage charge. The service availability charge can be determined as the residual component to be recovered to meet the revenue requirement after the revenue from water usage charges has been estimated. The revenue to be recovered through the service availability charge should be calculated as the difference between the total revenue requirement, and the revenue recovered through water usage charges and developer charges (costs of new or upgraded infrastructure required to service a given region or development) (NWI 2010, p. 9). The usage component of the charge, known as the inclining block tariff or two-part tariff, has been adopted by many Australian jurisdictions. It is generally set with reference to long-run marginal cost of supply (NWI 2010, p. 9). 309

312 The key difference and the degree to which urban and regional water businesses achieve full cost recovery vary widely across Australia. These are identified by the NWI (2011) as follows: The ESC in Victoria regulates the prices in all metropolitan, regional and rural water services. It is progressing towards upper-bound cost recover. In Queensland and New South Wales, local councils provide regional urban services. Surprisingly, local councils are not subject to economic regulation, which means local councils water prices are not closely scrutinised. Instead, local governments have their compliance with cost recovery assessed via reporting against guidelines and benchmark returns issued by governments such as the New South Wales Best Practice Management of Water Supply and Sewerage Guidelines Many non-metropolitans in South Australia, Western Australia and the Northern Territory do not achieve full cost recovery. In fact, these governments fund revenue shortfalls and adopt uniform state pricing policies. Currently, Western Australia is phasing in more cost-reflective charges for both country commercial and high-use residential consumers. Three regional water businesses in Tasmania Ben Lomond Water, Southern Water and Cradle Mountain Water generate rates of return below full-cost recovery levels. As of July 2009, a major restructure of the water business was undertaken, with a recent rise of water and sewerage charge price cap to 10 per cent to allow full-cost recovery for the businesses. All Australian jurisdictions, except for the Northern Territory and Queensland, demonstrate that they have achieved lower-bound pricing. Their price-setting processes are either consistent with or moving towards being consistent with upper-pricing for metropolitan water storage and delivery (Australian Government 2009, p. 159). The NWI (2011, p. 79) confirmed most metropolitan areas in Australia have arrangements in place to achieve upper-bound cost recovery. However, significant differences can be identified in levels of cost recovery, depending on accuracy of a number of underlying assumptions such as demand forecasts, projected costs and government policies such as specifying the WACC. 310

313 9.7 Summary of asset valuation techniques used by water utilities in major Australian jurisdictions A summary of recent findings from asset valuations considered in various utility businesses has drawn a conclusion that replacement cost accounting (i.e. DORC method) is not universally applied in Australia. The DORC has been accepted by both the Australian governments and regulators as one of a number of legitimate techniques for valuing utility assets. However, the fact that replacement cost accounting (DORC) has been adopted without any adjustment in a broad number of cases in Australia has confirmed that it is widely accepted as the principal asset valuation method, and that it is consistent with those observed in effectively competitive markets. The outcomes of a competitive market in turn provide a useful guidepost for regulation. In relation to water utility businesses, the COAG commissioned a report in 1994 on asset valuation techniques and cost recovery definitions to assist in the development of an appropriate water pricing regime. Its main principle objective was to set up an efficient and sustainable water business (NERA Economic Consulting & PricewaterhouseCoopers 2009, pp. 2 & 20). Of the six states and two territories in Australia, finding concluded that two states and one territory, the Australian Capital Territory, Queensland and South Australia, have employed COAG Pricing Principles when valuing assets. Table 9.30 (below) provides a summary of the regulatory arrangements that were in place in each jurisdiction when values of assets were established (NERA Economic Consulting & PricewaterhouseCoopers 2009, p. 21). Furthermore, Table 9.31 provides a summary of the method used to determine initial asset valuation methodologies employed by each jurisdiction. It can be observed that consistent with COAG s Pricing Principles and its reform, Queensland, Australian Capital Territory, South Australia and Western Australia have explicitly employed the deprival value concept, which has resulted in a DORC valuation being adopted in both Queensland and South Australia, while the ODV, specifically the line in the sand or the EV option based 311

314 on existing prices, was adopted in the Australian Capital Territory, New South Wales and Victoria (KPMG 2007, pp ; NERA Economic Consulting & PricewaterhouseCoopers 2009, p. 21). In practice, it can be concluded that in many cases it is the line in the sand or the EV option based on existing prices, and not the DORC, that has been adopted in many of Australia s water utility jurisdictions. The line in the sand or the EV option based on existing prices is the lower-bound pricing and consistent with the ODV principle. For example, in Western Australia the ERA accepted the Water Corporation s proposed regulatory asset value of $ million as at 30 June 2005 as within the upper-bound pricing range. The DORC determination of this initial asset value would result in a substantial increase in the Water Corporation s revenue requirement, and could potentially result in a regulatory price shock if this cost-based regulation was introduced. Regulatory asset value of $9 100 million, based on the EV option on existing prices, were instead accepted (Department of Treasury and Finance Draft Report Submission, p. 17, cited in ERA 2005, pp ). It makes sense that when a business acquires assets the business takes the view that the returns it will enjoy through ownership of the asset. That is, the returns that it will enjoy through the ownership of the asset (and jointly with other assets) will exceed the price paid to acquire the asset. The DORC replacement cost provides a ceiling (upper-bound pricing) on the value of the asset. That is, if the entity was deprived of the asset, it would not lose its future returns; its loss would simply be the cost of replacing the asset. That cost captures the extent to which the asset makes the entity better off. It ensures that future (unearned) returns are not anticipated, but are reflected only when they arise via use or disposal of the asset (Lennard 2002, pp. 6 7; Lennard 2010, pp ). The deprival value from an accounting perspective is the value of an asset to the current owner if the owner is deprived of the asset. That is, if the owner was required to continue to deliver the same level of service, the assets have to be valued at an amount that represents the entire loss that might be expected to be incurred if the entity were deprived of the service potential of future economic benefits embodied in that particular asset at the reporting date (Framework for the Preparation and Presentation of Financial Statements, paragraph 49(a) AASB 2013, p. 30). That cost is the EV of the asset and the lower-bound 312

315 pricing. The deprival value is a valuation rule which reflects a non-market concept of the value in the use of assets as part of a going concern; a GAAP convention applied by accountants. Table 9.30: Jurisdictions which have employed the COAG Pricing Principles when valuing assets Jurisdiction Australian Capital Territory New South Wales Queensland South Australia Victoria Regulatory instrument/ terms of reference Government initiated inquiry into water and wastewater prices The review of maximum prices charged by Sydney Catchment Authority is initiated by the government Inquiry into pricing principles is initiated by the government for GAWB Inquiry into process of developing urban water and wastewater prices is initiated by the South Australia Government As required by Water Industry Regulatory Order 2003, ESC must undertake a review of prices proposed by urban and rural water businesses Asset valuation principles No specific asset valuation principles set down in terms of inquiry; reference made by Independent Pricing and Regulatory Commission (IPRC) has complied with COAG Pricing Principles IPART relied upon external assessment of different valuation methodologies; no specific asset valuation principles were set in its price determination Pricing framework developed by GAWB was based on COAG Pricing Principles; no specific asset valuation principles were set down in terms of inquiry ESCOSA directed to have regard to the COAG Pricing Principles No specific asset valuation principles specified in the legislation or terms of inquiry; Minister for Water indicated that an EV approach would be employed. As at 1 July 2004, the Minister for Water was accorded responsibility to determine the value of assets under this order; it then directed the ESC to 313

316 Jurisdiction Regulatory instrument/ terms of reference Asset valuation principles advise on the value attributed to each business (NERA Economic Consulting & PricewaterhouseCoopers 2009, p. 21) Table 9.31: Water industries regulatory instrument and asset valuation principles Jurisdiction and regulator ESC Victoria ESCOSA South Australia IPART New South Wales IPRC Australian Network Asset valuation is determined by Asset valuation method used to determine RAB 18 rural and Vic Govt Line in the sand. In regional , asset values water assumed for most businesses businesses were based on its expected returns (EV). If the ESC concluded that there was a risk to the business s financial viability, a higher asset value would be adopted by the Minister SA Water SA Govt Deprival value approach, DORC Sydney Regulator Line in the sand, that is Catchment economic valuation based Area on prices in 1996 determination ACTEW Regulator Line in the sand, that is Water and economic valuation based Role of prices in determination of RAB Asset base for most assets was set by reference to prices, unless business s financial viability was at risk N/A Asset base was set by reference to 1996 tariffs Asset base was set by reference to 314

317 Jurisdiction and regulator Capital Territory QCA Queensland Network Asset valuation is determined by Asset valuation method used to determine RAB Sewerage on existing prices; EV $130m was lower than DORC value GAWB Regulator Deprival value approach, DORC Role of prices in determination of RAB existing tariffs (NERA Economic Consulting & PricewaterhouseCoopers 2009, p. 22) 9.8 Is the price of water high or low? Many scholars such as Bonbright (1937, p. 1139), Solomon (1971, p. 111), Bertram (2000, pp ) and King (2000, p. 2; 2001, pp ) have noted that DORC valuation of assets is the maximum valuation which would prevent system bypass of the assets. Figure 9.4 (below) shows that the gap between ORC and DORC asset value is monopoly rent. The DORC asset value sets the upper limit to asset valuation, and this is what it attempts to measure. This is why the water regulator designed a reference tariff or revenue tariff policy to provide water businesses with the opportunity to earn a commercial stream of revenue known as the upper-bound pricing (Independent Pricing and Regulatory Tribunal 2000, p. 180). Figure 9.4: The gap between the ORC and DORC asset value 315

318 ORC (optimised replacement cost) DORC (depreciated optimised replacement cost) is the upper-bound pricing Evidence suggests that the price of water captured through the RAB calculation under the ODV does not capture any degree of monopoly profit. This valuation approach is sensible, given that water prices are influenced by non-economic considerations. In recent years, water prices have been rising at a rate greater than inflation across Australia because of the need to increase investment to replace ageing infrastructure, and to expand existing infrastructure such as recent capital works programs (desalination and recycled plants) and rising operating costs. One main reason for the increase in capital expenditure is because of the construction of desalination plants in Sydney, Melbourne and Adelaide. These plants are built to reduce the reliance of urban water suppliers on rainfall, but the increase in capital expenditure will result in a higher RAB (through the return on and of capital), which will contribute to higher annual and future year revenue requirements. Both governments and regulators have found it necessary to balance the need to recover revenue with the consumer s ability to absorb the price increase. Figures from the Australian Bureau of Statistics (ABS 2013) revealed that water prices had increased by 18 per cent in the past year. Water pricing is kept low for social policy reasons; at an average of $1.77/ kl in , increasing to $2.10/ kl in , $2.44/ kl in and $2.72 in Detailed information on the current water price structure is provided in Appendix 2. Some people believe that because water is a basic human need it should be free; for the same water quality, some Australians are willing to pay more than a thousand times the price for bottled water over tap water. In some public places, water is available for all, 316

319 which means the government virtually gives away water for free because water price is politically sensitive. Most recently, Melbourne Water which services the city s three water retailers (Yarra Valley Water, City West Water and South East Water) and is owned by the Victorian Government, is believed to have collected an extra $306 million (equivalent to an average of $177 per household) from consumers. The fees were to help cover capital expenditure for the Wonthaggi Desalination Plant. The Baillieu Government ordered Melbourne Water to refund the money it has had overcharged consumers, which was expected to begin during Water Plan Three, starting on 1 July From July to September 2012, water businesses estimated that $26.4 million was returned to customers, most of which was returned through the price freeze and top-up payments in customers bills for Additional amounts may be returned in the form of further rebates (Wells 2012; Wells & Levy 2012 & McArthur 2012). The key difference in the RAB applied in water businesses compared with those of other utilities is observe by Marsden Jacob Associates (2006, pp ) and NWI (2008, p. 9). That is, the RAB and the MAR used in water businesses are well below the replacement cost of infrastructure and the benchmark for setting asset values in other utilities. In particular, Marsden Jacob indicated that if the same approach was applied for water as with other utilities, based on figures obtained from WSAA facts (2005; cited in Marsden Jacob Associates 2006, p. 47), revenue levels across Australian capital cities could potentially increase on average by as much as 33 per cent. The combined annual revenue for Australia s eight capital cities water businesses could be up to $600 million higher per year and still remain within the upper-bound of efficient pricing levels. By comparing current revenue levels with the indicative full-cost estimates and assuming that full cost were to be defined in the same manner as in other utility businesses, the level of cost recovery for water businesses is only 75 per cent, with Melbourne estimated from a low cost recovery of 68 per cent to a high of almost 87 per cent for Hobart. 317

320 This means that the level of water prices and revenue set by economic regulators is below the maximum level consistent with a competitive market. The price of water set by Australian economic regulators is sufficient only to recover future expenditure to encourage investment in the business. Water businesses received low returns on investment; they are compensated for new investments only, not for past investments. In other words, all of Australia s major urban water businesses are charging just enough to cover their minimum cash flow requirements, including debt and interest repayments. None of the businesses are charging high prices to earn a commercial return on existing (sunk) assets. 318

321 9.9 Summary The seven different asset valuation techniques used in this thesis have resulted in significantly different valuation figures for the same assets. These differing asset valuation figures not only produce different estimates of the RAB, but also produce different water pricing and investment signals. The correct asset valuation method used should provide incentives for economic efficiency; most importantly to ensure both minimum cost to society, as well as continual investment in utility businesses in the most efficient way. Evidence compiled from Chapter Eight suggested that replacement cost will yield highest asset value, followed by DRC, ORC, DORC and ODV. The asset valuation under DAC and DIHC techniques will result in underestimation of RAB. This will result in water businesses not having sufficient revenues to finance capital investments and poor pricing signals will be reflected. Overall, comparisons of different asset valuation techniques revealed that there is no single asset valuation method that will provide a perfect asset valuation figure. That is, no specific asset valuation method is superior to the others. Without the existence of a competitive market for water businesses, asset valuation techniques are preferable to replicate as close as reasonably possible to those in a competitive market. This is what ODV and DORC attempts to measure. The main reason why asset valuation is needed in utility businesses was because it served as a basis for economic regulation to measure RAB and to revalue the businesses assets over time. In doing so, efficient pricing can be achieved. However, water utility businesses are unique given that there is no market value for their infrastructural assets. Experience with the use of DORC in water businesses is low compared with other utility businesses such as gas, electricity and rail. It has been suggested that this is perhaps reflecting the reduced level of competition in the water business. The specific asset valuation method used by water utility businesses to calculate the cost that they would incur and the revenue they would forgo when they are deprived of their asset is the ODV. The ODV as a variant of the deprival value relies on the deprival value 319

322 concept and, in theory; an optimised network would be used. The main principle underlying ODV is that it provides the basis for an adequate but not excessive return on capital, and promotes prudent investments. ODV of an asset is the lower of either the DORC if the assets can be replaced, or the EV which is the recoverable amount as appropriate. In simple terms, the ODV is a valuation rule that prescribes the value of the upper and lower boundaries for specialised assets, such as water assets. The ODV of an asset is the lower of either the DORC or the EV. In theory, the DORC is the replacement cost as well as the absolute upper limit of the deprival value concept. It is also the upper-bound pricing described in the COAG Water Resource Pricing Principles. The result of the first regression analysis confirmed that DORC asset valuation technique is the upper-bound pricing and is associated with higher asset valuation. DORC asset valuation technique resulted in higher price of water and higher level of capital expenditure by the business. On the other hand, the lower side of the ODV is bounded by the EV, specifically the NRV, which is also the lower-bound pricing described in the COAG Water Resource Pricing Principles. The result of the second regression analysis confirmed that line in the sand; EV asset valuation technique is the lower-bound pricing and is associated with lower asset valuation. The EV asset valuation technique resulted in lower price of water and lower level of capital expenditure by the business. The ODV is not essentially or necessarily the DORC. If the system was deprived of the asset, it would be replaced with the technically optimum equivalent. However, the EV may be less than its DORC when the business is deprived of an asset. If this is the case, the deprival value of the asset (i.e. its EV) is the greater of the NPV of expected cash flows from its continued use (that is the present value of expected cash flows). The RAB is the value as the sum of the discounted cash flows associated with each asset. It is the value to the user of the asset, or the NRV of disposing of the asset (i.e. the amount that could be realised by the sale of the asset); that is, its disposal or recoverable value. It is it not easy and often questionable to estimate the cash flows that are expected to be generated by each asset or by discounting the value back to present values using risk-adjusted discount rates. 320

323 The national blueprint for water reforms is the NWI. The upper-bound pricing of Water Resources Pricing Principles provides guidelines to avoid monopoly rents. Paragraph 5 of the NWI Pricing principles states that a water business should recover no more than the operational, maintenance and administrative costs, externalities, taxes, provision for the cost of asset consumption, and cost of capital. This is the DORC valuation when implemented correctly. It is the asset value consistent with the price that would be charged if a hypothetical (efficient) new entrant enters the market. Any prices set higher than those earned in a contestable market would contain monopoly rent. Local councils provide regional urban services in Queensland and New South Wales. They comply with cost recovery assessed through reporting against guidelines and benchmark returns issued by local governments. State governments in many nonmetropolitans areas in South Australia, Western Australia and the Northern Territory fund revenue shortfalls and adopt uniform state pricing policies because these areas do not achieve full cost recovery. The price of water captured through the RAB under the ODV does not consider any degree of monopoly profit. Water prices have been rising at a rate greater than the inflation across Australia due to the need to increase investment to replace ageing infrastructure, to expand existing infrastructure and to meet rising operating costs. Construction of desalination plants in Sydney, Melbourne and Adelaide is one of the main reasons for the increase in capital expenditure, which has resulted in higher annual and future year revenue requirements. A water business as a natural monopoly that sets the price of water directly from the value of its assets (RAB). An increase in asset value will have a direct impact on the price of water. Regression analysis confirmed the hypothesis of this thesis, that there is a direct relationship between investment in water assets which impacts on the RAB and ultimately the price of water. However, customers should not be made to pay for the increase in the price of water if the water business effectively earns a return on and of capital above what is invested. A conclusion can be drawn from the most recent findings that DORC methodology has not been applied universally throughout Australia. The deprival value methodology is recommended for the purpose of asset valuation and the determination of water utility businesses revenue requirements. 321

324 This thesis findings concluded that out of five states in Australia, three states/territories (Australian Capital Territory, Queensland and South Australia) have employed COAG Pricing Principles when valuing assets. In addition, consistent with the COAG s Pricing Principles and its reform, four states/territories (Australian Capital Territory, Queensland, South Australia and Western Australia) have explicitly employed the deprival value concept. A DORC valuation has been adopted in Queensland and South Australia, while the ODV, specifically the line in the sand or the EV option based on existing prices, was adopted in the Australian Capital Territory, New South Wales and Victoria. It can be concluded that it is the line in the sand or the EV option based on existing prices and not the DORC valuation that has been adopted by most water businesses in Australian jurisdictions. The next chapter is the final chapter, which will summarise and conclude the entire research thesis. 322

325 Chapter Ten: Summary and Conclusions 10.1 Introduction This chapter provides a summary of the entire thesis, the hypothesis of the thesis and its key findings. Aligned with the general structure of this thesis, this chapter begins with a discussion on some of the basic characteristics of urban water. A recent rise in rainfall across eastern Australia in areas including South East Queensland and New South Wales has caused a rapid rise in storage levels in many of Australia s catchments. As a result, most water utilities have been able to ease water restrictions and/or move to permanent water conservation measures. The recent rise in rainfall and the Queensland floods (early 2010) highlight Australia s extreme climate variability and the ongoing water challenges. As a natural monopoly, it is more economical for one water business with technology and consumer demand to serve the one relevant market than for several businesses to do so. Competition is often not possible and there are high barriers to entry. In addition, water consumers cannot change providers. In line with this, regulation ensures that water supply businesses earn enough to cover operating costs, depreciation and a modest return on capital. At the same time, water prices are kept as low as possible by the regulatory authorities. Next, this chapter discusses the current urban water pricing approaches, which vary across Australian jurisdictions. The main difference is in pricing functions among regulators and reviewing bodies. As most Australian jurisdictions comply with the NWI Pricing Principles and commitments, water businesses have adopted two-part tariffs for efficient water pricing in Australia and elsewhere in the world. In 1994, as part of the water pricing reforms and its institutionalisation, the COAG set up its Strategic Water Reform Framework. The NWI became the blueprint for water reforms in 2004, and its pricing principles were endorsed by the Natural Resource Management Ministerial Council in

326 Having established the water pricing reforms, what follows on is a discussion on the research hypotheses used and the thesis s key findings. The standard approach used by most regulators to regulate utility sectors (including water) in network infrastructure is the building block approach. The valuation of RAB is important in this component of cost. Limitations as well as suggestions for future research are also discussed in this chapter Outline of the thesis Water is known to be the most precious of all natural resources, as it is not possible for any life human, animal or plant to survive without water. The Australian urban water industry experienced a positive change in due to increased rainfall across eastern Australia (including South East Queensland and areas of New South Wales), leading to rapid rises in storage levels in many of Australia s catchments. Most water utilities were therefore able to either ease water restrictions or move to permanent water conservation measures. Australia s extreme climate variability and ongoing water challenges were evidenced through Queensland s flood in early Water businesses are natural monopolies where the largest supplier has an overwhelming cost advantage over actual and potential competitors. It is more economical for one business with technology and consumer demand to serve the relevant market than for several businesses to do so. Water assets such as pipelines are very expensive to build or duplicate, which means that there are high barriers to entry and competition is often not possible. Other characteristics of the water industry are such that there are large sunk investments, and a large share of fixed costs and economies of scale and scope, which means that a potential competitor is unlikely to be willing to make the capital investments needed to enter the natural monopolist s market. It is cheaper for a single entity to provide the service. Unlike other utilities, water consumers cannot change providers, as water businesses provide services within a defined geographical area. It is therefore necessary for water prices to be regulated as an integral part of the transformation. In Australia, water supply 324

327 businesses are highly regulated. Water prices are determined by regulatory authorities and kept as low as possible. Many water supply businesses are government-owned entities. The current water pricing arrangements vary between jurisdictions, and the main difference is in pricing functions among regulators and reviewing bodies. In the Australian Capital Territory, Victoria and metropolitan water utilities in New South Wales, independent regulators set water prices for major water businesses and bulk water utilities. Prices are still controlled by state governments in other jurisdictions. Another significant difference is the coverage of economic regulations between jurisdictions. For instance, the IPART in New South Wales determines prices for metropolitan businesses and water planning and management charges. The State Water Corporation provides water services charged by local utilities in regional areas. In contrast, the ESC in Victoria determines water prices for all metropolitan, regional and rural water services, while in rural New South Wales and South Australia and Western Australia, private irrigation providers determine infrastructure charges paid by customers. Water prices are typified by a regulated approach based on the building blocks methodology with periodic price reviews (between three and five years); that is, the twopart inclining tariff, which consists of fixed and volumetric (variable) components. Every water bill incorporates a separate fixed charge and usage (variable) charge. The fixed component is set to ensure revenue adequacy the residual of the revenue requirement less total water usage charges. On the other hand, the volumetric (variable) component, also known as the inclining block tariff, is set with regard to the long- run marginal cost of additional supply capacity. The tariffs can comprise of one block (used by Sydney Water for economic efficiency reasons) or more blocks or tiers of up to 11 (used by Albany and Kalgoorie-Boulder Water Corporation in Western Australia). In practice, water businesses set a low water usage charge for the amount of water required to meet basic needs. Any amount of water usage charged in excess of this amount is billed at a higher rate. Water pricing reform and its institutionalisation began in 1994 when the COAG set up its Strategic Water Reform Framework. In 2004, the NWI became the blueprint for water 325

328 reforms, where nine jurisdictions were accredited with NWI plans. In 2010, the NWI Pricing Principles were endorsed by the Natural Resource Management Ministerial Council. The aim of these pricing principles is to ensure that water pricing is predominantly used to achieve economically efficient water use and water service provision, and that water businesses are financially viable Summary of the hypothesis of the thesis and key findings The hypothesis of this thesis is to test to see if there is a direct relationship between: (i) (ii) investment in water assets; does (i) impacts on the price of water and the RAB In chapter nine, the Least Squares Regression Method is used to test the relationship between asset valuation techniques (independent variable), prices, profitability and investment levels (dependent variable) in the industry, as well as the long-term viability of the industry. The Least Squares Regression Method was chosen for this thesis because the method estimated the true value of any quantities based on a consideration of errors in the observation. The method is used to predict the relationship between investment, that is net capital investment and asset valuation techniques used in water utility businesses in Australia. Secondary and archival data were collected from the WSAA website and water businesses reports over eight years from 2004 to Values of the independent variable (asset valuation techniques, length of pipes connecting residential properties water supply and the number of population connected to urban water services) were collected to predict the behaviour and value of the dependent variable (net capital expenditure). Dummy variables for asset valuation techniques are used because net capital expenditure (dependent variable) is influenced by not only the quantitative variables (length of pipes connecting residential properties water supply and the number of population connected to urban water services) but also the qualitative variables (asset valuation techniques, that is DORC and line in the sand, EV). For this thesis, the R-squared (known as the coefficient 326

329 of determination) for both regressions is or 76.9 per cent, suggesting that 76.9 per cent of the total variation in net capital expenditure (dependent variable) can be explained by its relationship to asset valuation techniques, length of pipes connecting residential properties water supply, and the number of population connected to urban water supply. As well, this means that 76.9 per cent of the total sum of squares can be explained by the estimated regression equation when used to predict or forecast future net capital expenditure. In the first regression analysis, dummy variables (independent variable) take the values of 1 for DORC and 0 for EV. The regression slope is 0.36 meaning that on average, every $1 increase in DORC asset valuation technique resulted in a 36 cent increase in net capital expenditure. Every 1 km increases in length of pipes resulted in cent increase in net capital expenditure. Every one increase in the number of population connected to urban water supply resulted in a negative cent in net capital expenditure. The coefficient of asset valuation is significant with a positive sign t-statistics of 3.8. DORC asset valuation technique (independent variable) has a significant positive impact on net capital expenditure (dependent variable). DORC asset valuation technique impacts positively on net capital expenditure. This finding supported the view that in theory, DORC asset valuation technique is the upper-bound pricing. Higher asset valuation resulted in higher price of water as well as higher level of capital expenditure by the water business. Likewise, in the second regression analysis when dummy variables (independent variable) take the values of 0 for DORC and 1 for line in the sand or EV, the regression slope was a negative This means that on average, every $1 increase in line in the sand, EV asset valuation technique will result in a 36 cent decrease in net capital expenditure. The hypothesis of this thesis has been supported by the findings of the two regression analysis. There is a direct relationship between investment in water assets which impact on the RAB and the price of water. Regardless of the asset valuation techniques used, there were no changes in the length of pipes and the number of population connected to urban water supply. A water business 327

330 invests in capital expenditure regardless of the asset valuation techniques used. The findings of the two regression analysis, particularly in relation to no changes observed in the length of pipes and the number of population connected to urban water supply is consistent with the argument made by Topp and Kulys (2012, p. 98). Water assets are constructed with a long term view to meeting not only current but also future demand. Capital expenditure invested in water assets increases in line with population growth and the available capital capacity. Topp and Kulys (2012, p. 98) argued that it takes many more years for the aggregate supply capacity to be fully utilised after investment is made and new water supply assets are operational. For example, it is not possible to raise dam levels every year. Pipes and wastewater treatment plants cannot be widened year to cope with the growing demand for water and wastewater treatment. There is a trend whereby once these lumpy new assets are constructed; capital expenditures will eventually slows down. This thesis answers the following key questions: explanation of asset valuation techniques used to estimate the MAR and the RAB for charging (pricing) purposes. The two asset valuation techniques used are the DORC and the EV asset valuation. This thesis also revealed how asset valuation techniques are applied, published statements in relation to these two techniques, arguments of regulators, completing missing details and essential mathematical connections. The building block approach is the standard approach used by most regulators to regulate utility sectors (including water) in network infrastructure. It consists of three main building block components a return on capital (allowed rate of return), a return of capital (depreciation), and an appropriate estimate of efficient operating costs. As a natural monopolist, a water business is considered a long-term, capital-intensive (in hundreds of billions of dollars) industry. Its assets are not only long-life and immobile, but once they are invested, they are considered sunk with no alternative use. Normative theories of accounting prescribe that assets should be valued using specific asset valuation techniques. While there is no one asset valuation method that is deemed perfect or entirely satisfactory, different techniques result in significantly different valuation figures for the same assets. For instance, estimates of RAB are different under significant asset valuation figures. 328

331 Paragraph 100 of AASB Framework of the Preparation of the Preparation and Presentation of Financial Statements suggests that the rules of asset valuation techniques vary across different types of assets, and a number of different measurement techniques and guidelines are employed to different degrees and in varying combinations in financial statements. In accounting there are two main measurable attributes in the measurement of assets (non-current), one of the main elements of financial statements; these are costbased techniques, based on the cost of purchasing the assets (historical cost and replacement cost), and value-based techniques, which is the NPV of cash generated from the business or the NRV from selling the asset. In theory, numerous accounting and financial literature have identified the present value model as the best accounting model for asset valuation. Under the present value accounting, assets are valued at their present discounted value of the future net cash inflows that they are expected to generate in the normal course of business. However, the practical deficiency of this model is that it lacks objectivity and is highly subjective, since it requires not only the estimation of future net cash receipts and the timings of those receipts, but also the selection of appropriate discount (risk) rates. Given the uncertainty surrounding their use, this model can be impractical when implemented. The HCA is the dominant framework for recognition and measurement of assets; however, this foundation is being replaced by FVA. Both the HCA and the CCA are based on the concept of capital maintenance. However, the main disadvantage of both of these techniques is that they do not recognise changes in the purchasing power of the dollar. That is, water business assets are long-life ( years) and these assets are purchased and invested at various points of time and subject to different price levels. Historical cost figures have limited application under these conditions. It is essential that a common understanding be established to justify why deprival value stands as the recommended method in Australia. There is very limited academic research published in relation to this methodology, particularly in relation to asset valuation and the determination of water pricing. In addition, research into the effects of rate regulation and prices in utility businesses not only vary widely but are also limited. 329

332 This research revealed that deprival value is the preferred asset valuation method for water businesses, as it is recognised by four important organisations: the COAG, the Steering Committee for National Performance Monitoring of Government Trading Enterprises, the NWI, and the Natural Resource Management Ministerial Council. Water businesses assets do not have alternative uses, and effectively they are considered sunk costs. There is no accounting or economics theory which provides the determination of an initial RAB value for the assets of an established water business. Economic theory suggests that the setting of a regulatory value for monopoly network assets at a particular time are typically interpreted as within a feasible range; that is, at upper- or lower-bound. The ODV, a variant of the deprival value, relies on the deprival value concept. It is only the valuation rule that prescribes the value of upper and lower boundaries for specialised assets (water assets). The ODV is the lower of the DORC if the assets can be replaced or the EV, the recoverable amount, as appropriate. The DORC is not only the replacement cost, but also the absolute upper limit of the deprival value concept, also described as lower-bound pricing in the COAG Water Resource Pricing Principles. The lower side of the ODV on the opposite side is bounded by the EV, specifically the NRV, which is also the lower-bound pricing described by the COAG Water Resource Pricing Principles. It is important to note that the ODV is not essentially or necessarily the DORC. It is only the appropriate value for the asset if the DORC of an asset is lower than its EV. The asset would be replaced with a technically optimum equivalent asset if the system was deprived of the asset. Alternatively, the EV forgone may be less than its DORC when the business is deprived of an asset. The deprival value of the asset is its EV; that is, the greater of the NPV of expected cash flows from its continued use. The sum of the discounted cash flows associated with each asset is the RAB. This is the asset disposal or recoverable value, which is the value to the user of the asset or the NRV of disposing of the asset. That is, this is the amount that could have been realised by the sale of the asset. However, the estimated cash flows that are expected to be generated by each asset or discounting the value back to present values using risk adjusted discount rate is not only difficult but also questionable. 330

333 The ODV concept is used for statutory reporting and performance monitoring purposes to determine the price of water. Paragraphs OB 4 and OB 16 of Chapter 1, Objective of General Purpose Financial Reporting of the AASB CF Amendments to the Australian Conceptual Framework (December 2013) proposes that a water business is able to discharge public accountability via maintenance of relevant and reliable information required in its audited financial statements. Asset valuation and specifically the ODV concept is consistent with the going concern and prudence or conservatism of GAAP and paragraphs 7, and 33 of IAS 16/ AASB 116 Property, Plant and Equipment (June 2009). The going concern notes that the business will continue in the future, while the prudence convention states that accountants should recognise losses in the value of assets as early as possible. Gains should only be recognised when they are certain and the amount is realised. Assets are to be valued so as to provide a relevant and faithful representative for economic decision-making. Paragraph 7 of IAS 16/ AASB 116 (June 2009) states that the cost of property, plant and equipment shall be recognised as an asset if it is probable that future economic benefits associated with it will flow to the entity, and the cost of asset must be measured reliably. Paragraphs state that property, plant and equipment (the water utility s assets) should be valued at either the lower of cost or recoverable amount ; that is, the amount expected to be recovered in future cash flows through use and/or sale of the asset. That is: The ODV = lower of DORC (replacement cost) / recoverable amount (i.e. the higher of NPV/NRV), or equivalently. In addition, paragraph 33 of both the International and Australian Accounting Standards states that where there is no market-based evidence of fair value because of the specialised nature of the item of property, plant and equipment and the item is rarely sold, except as part of a continuing business, an entity may need to estimate fair value using an income (NRV) or a cost (DORC) approach. From the most recent findings in Chapter Nine, one can conclude that the DORC method is not applied universally throughout Australia. Even though the deprival value methodology is recommended for the purpose of asset valuation and determination of 331

334 water utility businesses revenue requirements, only three out of the five Australian states and territories (Australian Capital Territory, Queensland and South Australia) have employed COAG s Pricing Principles when valuing assets. Four states/territories (Australian Capital Territory, Queensland, South Australia and Western Australia) have explicitly employed the deprival value concept, consistent with the COAG s Pricing Principles. Queensland and South Australia have adopted a DORC valuation, while the ODV method, specifically the line in the sand or the EV option based on existing prices, was adopted in the Australian Capital Territory, New South Wales and Victoria. In many cases it can be concluded that it is the line in the sand or the EV option based on existing prices and not the DORC valuation that has been adopted in many water businesses in Australian jurisdictions. Key findings from Chapter Nine also revealed that the RAB applied and the MAR used are well below the replacement cost of infrastructure and the benchmark for setting asset values in other utilities. If the same approaches were applied for water as with other utilities, revenue levels across Australian capital cities could potentially increase by an average of as much as 33 per cent. In total, the annual revenue levels for Australia s eight capital cities water businesses could be up to $600 million higher per year and still remain within the upper bound of efficient pricing levels. The level of cost recovery for water businesses is only an average of 75 per cent; from a low cost recovery of 68 per cent in Melbourne to a high cost recovery of 87 per cent in Hobart. The DORC valuation of assets is the maximum valuation that would prevent system bypass of the assets. It sets the upper limit (upper-bound pricing) to asset valuation; what it attempts to measure. However, regardless of the depreciation method used, the DORC valuation is the cost to construct or replace the exact same asset today. For this reason, it delivers a high asset value compared with valuation techniques discussed. The gap between ORC and DORC asset value is called the monopoly rent. The price of water capture through RAB calculation under the ODV does not capture any degree of monopoly profit. As an essential component of all life, governments take a special interest in the security, sustainability and pricing of water. Australian economic regulators set water prices just sufficient to recover future expenditure, to encourage investment in the business. Since water businesses receive low returns on investment, they are only compensated for new investments and not for past investments. 332

335 One of the most difficult, controversial and challenging issues associated with determining the revenue requirement of a water service provider is the asset valuation technique used in the determination of the RAB. As valuation of water utility assets is not related to a competitive market, there is no specific procedure for asset valuation which is necessarily correct or suits all accounting, performance monitoring and price regulation. Asset valuation is needs in utility businesses to serve as a basis for economic regulation to measure the RAB and to revalue the businesses assets over time for the purpose of determining the price of water. The ODV (i.e. the DORC and the EV option based on existing prices) is superior, because it provides complex but sophisticated measures of the RAB by eliminating inefficiencies in the business s current asset configuration. The two asset valuation techniques attempt to measure and very closely replicate those techniques in the competitive market. At the same time, the two techniques address the economic efficiency criteria far better than any other asset valuation techniques. The relationships between the two asset valuation techniques and the pricing of water must be clearly understood. In doing so, regulators are able to create transparency in their pricing decisions. This thesis concludes that the current urban water pricing policy in Australia allows for urban water businesses to recover only a modest return on and of capital, and barely recover the sum of operating expenses and tax obligations. Regression analysis confirmed the hypothesis of this thesis, that there is a direct relationship between investment in water assets which impacts on the price of water and the RAB. Over several decades, the water industry and its businesses have generated minimal to no-profit (negative or low return on assets) pricing, which has implications on their long-term viability. In addition, these raised two important questions: first, whether the water resources are efficiently used by consumers; and second, whether water prices provide correct signals for efficient investment. Since water is an essential component of life, the average price of water at $2.72 per kl in is considers very low. It does not signal to consumers the scarce value of water. As the most basic essential resource, humanity places very little value on water. 333

336 Yet there is no question that water is essential for the development and sustainability of any country. The affordability and availability of water is fundamental to maintaining a high living standard for all Australians, and the true economic benefits of water utility assets are enjoyed by many Australian businesses and households that receive a clean and reliable water supply at a price kept low by the regulatory regime and the government. The question of whether deprival value is the appropriate asset valuation method to be used by the water industry for charging (pricing) purposes is difficult to answer, and is often debated by academics and practitioners. The fact is that the DORC and the line in the sand or the EV options communicate the cost of replacing the potential service capacity or future economic benefits of the assets when the assets are destroyed or lost. This asset valuation reflects the worth of assets to consumers, and it is the value reflected to the public and water consumers. On the contrary, the underlying value of assets is determined from their ability to generate future cash flows, in order to provide monetary returns to water businesses. In this circumstance, the NPV of the cash flows generated from the use of assets (EV) is less than the DORC. Without any further economics and/or accounting theories, as well as the absence of authoritative accounting guidance from Australian and international accounting standards, the DORC and the EV option based on existing prices would appear to be a valid asset valuation technique. To date, the NWI Pricing Principles and the COAG do not have any specific asset valuation guidelines or publication in relation to water industry and deprival value method. The appropriateness of adopting these two asset valuation techniques is a matter of judgement. It is subjective and difficult to implement because of the measurement challenges it presents, and should be considered by the water industry on a case-by-case basis, within their specific circumstances. 334

337 10.4 Limitations of the research This study investigated only a sample of water utility infrastructure assets and their relation to water pricing, for which the necessary data was readily available. The conclusions drawn are based on the data collected, and as a case study and exploratory study, the regulatory period differs according to jurisdictions. The samples collected for this project were collected from industry reports (simulation process), and due to limited data availability in the water industry, asset valuation figures were based on other utility businesses such as gas and electricity. Conceptually, the ODV method was based on prices set in a hypothetical long-term competitive market where supply and demand will balance, and where the assets are short-lived and non-lumpy. The fact is that there is no market for water infrastructure assets, as effectively these assets are considered sunk. That is, as specialised (infrastructure) assets, they have few, if any, alternative uses once built. Past investment is used (in the calculation of revenue) at the time when the investment is made, and is reflected in current and future water prices. The assets classes as well as sub-major assets have not been investigated in any detail due to the lack of asset data available from industry reports. Academic research into asset valuation and pricing of water utilities is by far very limited. Also, due to the lack of competition in the water business, a comparison of asset valuation techniques is also limited. The regulation and reform of the water industry is very new and is still developing in many ways. Accounting for asset valuations and water utility pricing is therefore a relatively new research area Suggestions for future research A limitation of this study is its sample size, which is based on information collected from various industry reports and the best information available at that time. This research is based on case study (exploratory) methodology, and it might be useful if future research is conducted via surveys of water utility businesses, specifically in the area of recording how they value their assets. Other areas of potential interest include step-by-step 335

338 instructions on how water businesses conduct their asset valuations using deprival value and/or the DORC method. Future research could concentrate on providing detailed information on how water businesses conduct the process of optimisation. In this thesis, return of capital (i.e. depreciation) is the dependent variable. Further potential research could look into the impact that depreciation has on utility prices. At present, there is very limited accounting or economics literature on such issues. 336

339 10.6 Summary Water is known as the most precious natural resources for any life; human, animal or plant. In , the Australian urban water industry experienced a positive change, as water storage levels in many of Australia s catchments rose because of the increased rainfall across eastern Australia (including South East Queensland and areas in New South Wales). Most water utilities therefore eased water restrictions or moved to permanent water conservation measures. Water businesses are natural monopolists, where the largest supplier has an overwhelming cost advantage over actual and potential competitors. It is also necessary for water prices to be regulated as an integral part of the transformation, since water consumers cannot change providers. Regulation allows service providers to hold a level of power that enables them to price at a level that delivers greater than normal commercial return and/ or provides substandard levels of service. The findings of the regression analysis confirmed the hypothesis of this thesis. There is a direct relationship between investment in water assets which impacted on the RAB and ultimately the price of water. DORC asset valuation technique is the upper-bound pricing and associated with higher asset valuation. Higher asset valuation will result in higher level of capital expenditure by the business and consequently higher price of water. Similarly, EV asset valuation technique is the lower-bound pricing. EV asset valuation is associated with lower level of capital expenditure and consequently lower price of water. The main difference in current water pricing is in pricing functions among regulators and reviewing bodies. Water prices are regulated based on the building blocks methodology, with periodic price reviews between three and five years. Every water bill incorporates a separate fixed charge and usage (variable) charge. The fixed component is set to ensure revenue adequacy. The volumetric (variable) component is also known as the inclining block tariff, and is set with regard to the long-run marginal cost of additional supply capacity. 337

340 The building block approach consists of three main building blocks ; that is, return on capital (allowed rate of return), return of capital (depreciation), and an appropriate estimate of efficient operating costs. The building block approach is used by water businesses to determine the amount of revenue to allow them to operate and remain viable. The key ingredient of the building block approach is the RAB comprising of the physical assets. No one asset valuation is perfect or entirely satisfactory. In accounting, the two main measurable attributes related to alternative asset valuation techniques are the cost-based techniques based on cost of purchasing the assets (historical cost and replacement cost), and the value-based techniques which represent the NPV of cash generated from the business or the NRV of selling the asset. The present value model is known to be the best accounting model for asset valuation. The NPV lacks objectivity and is highly subjective, since it requires estimation of future net cash receipts and the timings of those receipts, as well as the selection of appropriate discount (risk) rates. This model can be impractical when implemented, given the uncertainty surrounding its use. There has been very limited academic research published in relation to deprival value methodology; specifically its relation to asset valuation and determination of water pricing. Research regarding the effect of rate regulation and prices in utility businesses not only varies widely but is also limited. Its practical application in the real world is very limited. The setting of a regulatory value for monopoly network assets at a particular time has been suggested and interpreted in economic theory as within a feasible range, between upper- and lower-bound prices. The deprival value is the preferred asset valuation method for water businesses, and ODV is its variant, relying on the deprival value concept. It is consistent with prudence or conservatism GAAP and the IAS 16/ AASB 116 Property, Plant and Equipment (June 2009). Whether deprival value is the appropriate asset valuation method to be used by water businesses is questionable and often debated by academics and practitioners. There is no further guidance in economics and/or accounting theory, or Australian and international accounting standards, further explaining the appropriateness of the two options available 338

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368 Appendix 1: Examples of Optimisation The first example is of Filter Optimisation at Victoria s largest water treatment plant. The report provided by Jarvis (2005, pp ) sets out the steps in filter optimisation. Melbourne Water s Treatment Plant Winneke Water Treatment Plant, located north east of Melbourne, adjacent to Sugarloaf Reservoir, is an off line storage. Water is mostly pumped from Yarra River and Maroondah Aqueduct and depending on demand, Winneke Water Treatment Plant supplies up to 30 per cent of Melbourne s drinking water. Water is drawn from Sugarloaf Reservoir and the pumping station at the reservoir delivers it to the plant. Water is treated at Winneke Treatment Plant, at Sugarloaf Reservoir in Christmas Hills. Purification of the water occurs naturally due to long detention time in the major storage reservoirs and only minimal disinfection (by chlorination) is required to ensure that water is safe and healthy to drink. Filter optimisation is required as the Winneke Water Treatment has operated at flows greater than original intended capacity. Filters were operating significantly below optimal performance leading to a need for efficient filtration and backwashing an essential. Successful commissioning of water relies on having established filters and effective backwash sequence. There is a further driver for efficient filter operation. The current project is to increase Winneke s capacity to 620 ML/d. The new filter design and operation is based on existing filters. An audit was carried out and the consultant had identified a number of possible process improvements. First, the inefficient backwash sequence needs improvement; second, the media height differences on either side of the fillet gullet can be addressed; third, media losses can be reduced and finally, a number of other process improvements have been identified and rectified (e.g. flow hunting) as filtration involves a myriad of operating variables. Optimisation is considered a compromise between conflicting target parameters. Table 1: Original design manual backwash sequence 366

369 Step Blower Pump Duration 1 Blower (37.4 m/hr) OFF 2 Minutes 2 Blower (37.4 m/hr) 1 Pump (5.7 m/hr) 3 Minutes 3 OFF 2 Pumps (21 m/hr) 5 Minutes (Jarvis, 2005, p. 118) Note: These air and water flow rates are at near maximum available capacity. Table 2: Previous backwash sequence Step Blower Pump Duration 1 Blower (27.4 m/hr) 1 Pump (5.7 m/hr) 5 Minutes 2 Blower (27.4 m/hr) OFF 2 Minutes 3 Blower (27.4 m/hr) 1 Pump (5.7 m/hr) 1 Minute 4 OFF 2 Pumps (17.5 m/hr) 3 Minutes 5 OFF 1 Pump (12.4 m/hr) 5 Minutes (Jarvis, 2005, p. 118) Note: The sequence detailed above is similar to most of the 12 Winneke filters. Table 1 (above) shows the original design of backwash sequence while in Table 2 (above) the sequence used is shown. The backwash sequence included a number of steps provided minimal additional value and backwash water flow rates are not sufficient for adequate media expansion. The air scour rates are below the limits recommended for adequate flocculent break up. Moreover, each filter backwash sequence is different, which resulted in unequal performance. This inefficient backwash sequence was first observed during a 1997 upgrade and we can conclude that the Winneke filter backwash sequence strayed from the original design. A controlled upgrade should be followed, which means that the original design should be reviewed to ensure a reliable transition between systems. Treatment plant operating parameters should be regularly changed to accommodate for current climate, raw water quality and plant upgrades. In February 2005, in an attempt to increase backwash efficiency, the sequence was changed to closely follow the original design manual and reverting to the original design has resulted in significant reductions in backwashing time, volumes, energy consumption, operating costs and head loss. In regards to the filtered water flow control, for many years, only the clarifier outlet level was programmed to control. In contrast, the original plant design was intended to filter 367

370 water flow and be controlled from the level in both the clarifier inlet and outlet. A rapid control loop caused filtrate flow hunting of ML/d every hour which caused a number of process difficulties, most noticeable, chemical dosing control. In order to reduce flow variability, a trial began on July 2005 with filtrate flow to control flow, in accordance to the original design. It was found, as can be observed in the graph below, that the control changed on 4 July 2005, which includes clarifier inlet level, has resulted in reduction with hourly flow variability. Flow spikes in Figure 1 below indicate backwashing. The backwash water is supplied from the filtered water channel. Flow variation during backwashing is unavoidable without significant capital upgrade. Figure 1: Filtrate flow before and after control change (Jarvis, 2005, p. 119) Table 3 (below) outlines the flow and ph variability prior to and following control change. It is compiled by using all available July 2005 data (Jarvis, 2005, p. 119). Table 3: Flow and ph variability Flow Flow Std ph Variance ph Std Dev Variance Dev Prior to control